The Biofuel Bonanza

BIOFUELS 2006: HOW IS THE GLOBAL VALUE CHAIN SHAPING UP?
Switchgrass – reputed to be an energy
positive and carbon negative biofuel

Editor’s Note: Biofuel entrepreneur Louis Strydom reports from the Biofuels Finance & Investment World which was held in late 2006 in London, U.K. He brings some sobering macroscopic updates to our ongoing coverage of the biofuel phenomenon. One message coming from the Terrapinn conference was that the global biofuel industry is utterly dependent on government subsidies. Another was mention of the need for criteria for biofuel certification – criteria that must reach beyond the consumer and the refinery to the actual source of the feedstock.

In terms of impact on food production, sometime in 2007 world biodiesel consumption is expected to outstrip world soybean production, and also in 2007, US corn for ethanol consumption will again outstrip US corn exports. Because of land increasingly being allocated to growing biofuel, the global grain market reserves have fallen from 120 days in 2000 to an estimated reserve of only 40 days by 2008, with corn reserves projected at falling to even lower levels of 20 days reserves. With US corn, there is a significant gap between USDA projections for corn supply vs. the amount of corn required for ethanol production – requiring a further 15 million acres to be planted by 2010 just to negate this initial gap.


How competitive is biofuel, right now? On a strict energy-equivalent basis ethanol is competitive without subsidies at approximately US$ 60 per barrel in the US, US$ 35 per barrel in Brazil, and US$ 115 in Europe. The EU Commission estimates that biodiesel is competitive without subsidies at US$ 65 per barrel. Doesn’t Athabasca crude go for US$ 42 per barrel?

Touched on in this report are the efforts to build the biofuel industry in the developing world. The rapid construction of refineries in the developed world is based on the assumption that much of the feedstock will be imported from developing nations. Some sort of certification program is essential – biofuel is not always “carbon neutral” and having it is not worth losing what remains of our tropical rainforests. In the Congo deforestation accelerates to grow casava, in Indonesia for oil palms, in South America for sugar cane. This is a disaster.

There is no possible way to grow enough biofuel using conventional crops to feed the energy needs of the planet. We need factory farmed biofuel – which can still come from sunny nations – not tropical deforestation for biofuel plantations. On the other hand, efforts to build a biofuel industry in arid regions may have no downside. At a local level, farmers – and investors – can use hardy biofuel crops as pioneer crops to revitalize parched soil, combatting desertification; at the same time these crops yield oils and fuels which benefit the local economy. For more on such efforts, contact the Center for Jatropha Promotion (www.jatrophaworld.org in Churu, Rajasthan. – Ed “Redwood” Ring

Biofuels 2006 – How is the value chain shaping up?
by Louis Strydom, December 30, 2006
Tractor in Biofuel Field
The biofuel boom has changed the
game for agricultural commodities

The Terrapin Biofuels Finance and Investment World conference held in London in November of 2006 provided an excellent forum to come to grips with how the biofuels value chain is shaping up.

This article seeks to extract some of the insights delivered at the conference, and all figures are based on input from the various presenters, the comments and interpretations thereof are however the authors. Of course none of these figures, particularly the projections can be cast in stone, but it certainly offers some ideas of where the biofuels market is heading and where it will end up.

Product Definition and Subsidies

There appears to different but highly interrelated schools of thought on viable business models. Predominantly, this is driven by a first versus developing world perspective of investors and companies. At the root of these schools of thought, lies the issue of product definition.

In the post-industrial world, energy security and green energy are strong drivers, and government policies typically by way of incentives are the main drivers to this focus. This leads to a distinguishable product definition. If you define renewable fuel as “biofuel,” then ultimately one of the main customers is a government. This is because you are dependent on government subsidies as a material revenue stream to the biofuel business you engage in, whichever component(s) of the value chain you participate in. If you define your product as fuel, then your main customer is the end consumer of the fuel. The varying product definitions lead to different approaches and different points of participation in the value chain. I believe it is for this reason that we see a significant growth in both bioethanol and biodiesel refining capacity internationally and in particular in the first (post industrial, developed) world.

First World refineries are often driven by factors such as logistics and location, investment and plant cost, trying to optimize the refining capacity and quality, and feedstock supplies.

EXTENT OF BIOFUEL SUBSIDIES

- European subsidies are 3 times higher than US

- Export tariffs need to be lifted in Europe to assist meeting target consumptions of 2010 and 2020

- In 2020 with current targets, European biofuel subsidies might represent 23 times the European transport credits or 6 times those to research; Subsidies could represent 50% of agricultural budget or 20% of total EU budget.

- Put another way, subsidies might represent 70% of farmer’s revenue

TERMS OF BIOFUEL SUBSIDIES

A peculiar issue regarding investment in a subsidized market is that different investment return time horizons are applicable to various participants in the subsidized environment

- Farmers need a steady annual income

- Governments typically commit to a 3 to 5 year subsidy structure

- Investors require returns over a 5 to 7 year time horizon

- Industry requires 10 years plus period to write off assets

There is thus a mismatch between the time horizon requirements from the various participants and particularly from and investment perspective, which mainly drives the process, thus does cause uncertainty in terms of cash flow as a main revenue stream is subsidy income and thus changes therein will impact on investment.

ACTUAL MARKET COSTS FOR ETHANOL & BIODIESEL

From a numerical perspective it is interesting to note some of the following figures put forward:

- On a strict energy-equivalent basis ethanol is competitive without subsidies at approximately US$ 60 per barrel in the US, US$ 35 per barrel in Brazil, and US$ 115 in Europe

- The EU Commission estimates that biodiesel is competitive without subsidies at US$ 65 per barrel

THE LIMITATIONS TO SUBSIDIES

In general, subsidies have a curious nature. On the one hand they certainly can play a key role in society. So for example, public works spending during recessions can stimulate economies and literally pull them out of such dire periods. In the case of biofuels, subsidies can certainly pave the way for much quicker industry development. However, what is important to note is that long term subsidies are simply not sustainable and place a direct drain on the economy. To use a very simple example, if you walk up to someone in the street and ask him/her to give you US$ 100 because you can’t sell your baked cookies to Wal-Mart without this assistance, you certainly have a very slim chance of getting the money. If however you walked into government offices and asked for the same amount (and with a bit of lobbying) you’d have a rather high chance of success for getting the money. However, the government ultimately collects its monies from the citizens of the country, so in the end it is the same as having asked someone on the street for the 100 US$ in the first place!

Sustained subsidies lead to frictions such as experienced through the World Trade Organization regarding agriculture. So, although the involvement of government through subsidies plays a key role in many countries for the development of biofuels, it is vital to ensure that there is a much clearer long term policy that explicitly articulates long term involvement of government in the industry and what the exit plan is once the industry is established. If the plan is simply to continue subsidizing the industry then all that is happening is that you as the tax-payer will be burdened, indirectly making your fuel more expensive versus the price at the fuel pump.

Product Definition – A Change?

A topic that briefly surfaced was that of co-products. Of course when you import crude oil, or ethanol there is not much scope for the co-production as you are utilizing a processed product and thus earlier in the value chain the co- or by-products have hopefully been extracted and utilized. However from the total biofuel value chain perspective, these co-products can a) play a significant revenue enhancing role to the value chain and the cost of the product, and b) the co-products need to be dealt with as efficiently as possible because if you increase the value of the co-product you are decreasing your production cost per acre/hectare and thus you should be able to sell your primary product (fuel) at a lower price.

To do this it is necessary to redefine your product or business model (assuming you have some form of participative control of the value chain). So, for example, sugar co-products can produce electricity and thus you can move to a “bioenergy” product definition. Admittedly, a detriment to such a product definition has always been that the technology required to efficiently process the co-products have been lacking. Having said this, significant technological advances have been made over the past few years. From an energy perspective particularly in terms of cellulosic biomass, Combined Heat and Power (CHP) technology and gasification technology (both bio and thermal) as well as pyrolysis which has been around for some time. Therefore, if you expand your product definition to include some of these technologies in your processing of your harvest the ultimate IRR in the value chain can significantly improve. Being only a refiner of biofuel limits your ability to benefit in these co-product revenue stream enhancements.

Biofuel Plantation Aerial View
Biofuel from prairie grass is reputed to
be “carbon negative,” unlike many biofuels.

Feedstocks and Food Security

Some very pertinent figures where raised during the conference, for example:

- The US Biodiesel industry is expanding based on subsidies of US$1 per gallon or US$ 300 per ton;

- EU subsidies of US$ 450 allow Rapeseed to breakeven at per US$ 300 per ton;

- By 2007 world biodiesel consumption is expected to outstrip soybean production;

- By 2007 US corn for ethanol consumption will again outstrip US corn exports;

- Reflecting on world demand for vegetables oils and impact of biodiesel, Soft Seed oils (Sunflower and Rapeseed) production which usually responds to price and demand factors with a year to two years time lag, and are seen as the balancers for vegetable oil prices are currently producing at record highs. It follows that Soft Seed demand will significantly increase in the next few years due to increased demand caused by greater biodiesel refining and refineries;

- Similarly with US corn, there is a significant gap between USDA projections for corn supply vs. the amount of corn required for ethanol production (indicatively requiring a further 15 million acres to be planted by 2010 to negate this gap);

- Margin compression in biodiesel of feedstock cost versus net margin – in Germany margins are dramatically decreasing. Ethanol margin also compressing but not as significantly as biodiesel yet&

- The global grain market reserves have fallen from 120 days in 2000 to an estimated reserve of only 40 days by 2008, with corn reserves projected at falling to even lower levels of 20 days reserves.

In short it therefore seems that due to government subsidies aimed it bolstering refining capacity, a huge number of biofuel refineries have gone up in the last few years, this in turn has caused (and will continue to cause) a significant increase in demand for feedstock supplies. Currently a high percentage of the feedstocks are food based, and therefore there is now a new competing market for the feedstocks, which will price place pressures on feedstocks, more so, as the amount of land under cultivation for feedstocks is not keeping up with the demand.

Heat Map of the World
Biofuel can spell disaster to forests and yet pose
a challenge to deserts – where to plant is crucial.

So what then does the Developing World have to say about this?

If we take a step back and look at world energy demand, most projections seem to indicate that demand will double by 2030, the main growth driver being from the large emerging economies. But, the Developing world and in particular that part of the world between the Tropics of Cancer and Capricorn also has the most farmland available and generally the best climates to produce economically viable high yield biofuels (for example Brazil’s ethanol production or South East Asia’s Palm Oil production) . If that is the case, how are they viewing this surge in demand?

First, the emerging markets face significant pollution pressures. China, for example, is estimated to lose 8 to 12% of Gross Domestic Product due to pollution. The main drivers thereto are acid rain, diseases, disaster relief costs, and agricultural costs (loss of crops due to pollution, etc). Second, because the developing countries are the drivers for increased energy demand, energy security certainly places a key role for their government’s strategies. It can actually be argued that due to sub-optimal energy production and delivery in these countries, economic development can in some cases be retarded. Bearing these two factors in mind, simply out of an economic perspective it is difficult to see any clear motivation for a developing country to export biofuel or the raw products until its own energy demands are catered for as far as possible by renewable energy. This is a matter of concern for all the refineries going up in the first world, in as they look to lock in reliable supplies of feedstock.

And Corporate Governance? How does that fit into the picture?

Without going into too much detail on the topic, a simplistic model for some aspects of corporate governance is the Triple Bottom Line perspective “People, Planet, Profits” (http://en.wikipedia.org/wiki/Triple_bottom_line) – although there are arguments that the full concept is somewhat libertarian and idealistic, it does not detract from the fact that companies are responsible to all stakeholders (including society and the environment) in their business activities. Further, due to various legislations in Europe, UK, and the US companies are increasingly becoming responsible for their actions both locally and abroad. What relevance does this hold for biofuel projects? Whether you own your own crops, broker the commodities (crude vegetable oil or ethanol), or refine and produce the end biofuel, you are responsible to make sure that the crop and/or plantation is done in a socially and environmentally acceptable manner. This means that you cannot for example buy Crude Palm Oil from a plantation in a developing country where 100,000 hectares of rainforest has been burnt down to produce the crop. Neither can you buy such a product where the social impact of the crop or plantation has been to society’s detriment. Such actions will impede the success of your enterprise even if you are simply refining the commodity as you are ultimately contributing to destructive practices and will surely at some point face stakeholder and/or legal action.

Summary

Biofuel is one of the most global industries that mankind has undertaken, it affects everybody from the small-scale farmer in the developing world, to the corporation in the first world, to fuel consumers in every country. Admittedly Biofuel’s impact in statistical terms is still relatively small, but with the increase in biofuel production this impact will increase. The value chain is vast and stretches from a seedling to a consumer driving his car. It is a global matter and a strong case can be made for a more international involvement as the different points are affected at different times in the value chain as this industry develops. Even if your business model is only refining fuel, your business exposure is also agricultural and subsequent commodities.

Investors therefore need to accept that they will face both agricultural risks as well as refining and market risks – not that these cannot be managed; it is just that they will be exposed to them. Biofuels is not just a “green” industry with “green” money backing it, the market dictates the reality and viability of any venture and when the industry moves to market economics it certainly will provide a different value chain in the long run.

As a closing comment, someone at the conference jokingly said that in the next few years there should be a rather good business in brokering second-hand refineries if the excess production of capacity continues. In reality, this will probably not be the case, but a relook at the value chain and impact all the various parties are having on it will certainly change the biofuel industry of tomorrow.

Louis Strydom Portrait

About the Author: Louis Strydom is an expert in new venture creation and project finance with wide experience on projects in the developing world. One of Louis’ main projects for the last year has been conducting a pre-feasibility study and promotion of a 230,000 acre site for a Jatropha plantation and biodiesel refinery in Kenya. Previously he was Senior Vice President of Project Finance at Decillion – a company listed on the Johannesburg Stock Exchange. Other positions included Senior Economist managing the Credit Policy and Risk Management division of the Export Credit Insurance Corporation of South Africa. Prior to that he was a Director with Triumvirate responsible for Marketing and Consulting on Crisis Management. Louis also has extensive experience in short term insurance with American International Group on fire/casualty risks, niche products and political risks in Africa, Europe, the Middle East, UK and USA.

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