Monday Report - Betting on Biofuels June 11th, 2007

Economic Notes:

This Weeks Leads:

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Betting on biofuels

The industry is still in its infancy but evolving rapidly. Companies that hope to compete must devise their entry strategy now.

Billions of dollars, euros, pounds, and reais are pouring into biofuels. High fuel prices and generous regulatory support have given the industry healthy margins and relatively short investment payback times. Meanwhile, the triumphs of the first movers and dreams of future growth are enticing companies in industries from petroleum and agribusiness to biotechnology, chemicals, engineering, and financial services. And of course, the allure of a greener future has raised the expectations of investors and bystanders who hope that biofuels will help meet the world's energy needs while lowering greenhouse gas emissions.

Can biofuels deliver? The answer appears contingent on fuel prices as well as three other variables that directly influence the profitability and environmental impact of biofuels: the cost and availability of feedstock, government regulation, and conversion technologies. All are in flux, so an investment today is a bet on how these interrelated factors will evolve. Feedstock costs vary tremendously by region and could change significantly in the years ahead. Governments may alter the industry's ground rules to match changing priorities in climate change, energy security, and economic development. The energy, cost, and carbon efficiency of various biofuels are already quite different,1 and new conversion technologies could make them even more so-at different rates in different regions. Decisions about where to produce and distribute biofuels could have dramatic implications for the feasibility of the business.

Amid all this uncertainty, why enter now? In many commodity industries, the winners are the latest entrants, at the bottom of the cost curve-wielding the newest, most efficient technologies. But waiting may be a costly strategy in the nascent biofuel industry because land and other essential resources are at a premium.

Biofuel players should consider different ways to mitigate the risks, but every strategy will require trade- offs. Betting on a number of geographies and technologies will make things more complex, for example, but helps balance risk. Vertical integration, though both complex and costly, may be essential in helping to establish this young industry. Companies that want to play should try to get a head start on the difficult task of reducing the seemingly infinite number of options to a feasible set of solutions.

A world of uncertainty

Not long ago, the biofuel industry was relatively straightforward. Producers mostly used mature technologies and local feedstock to supply domestic markets with a single biofuel: bioethanol from cornstarch (in the United States) and sugarcane (in Brazil) or biodiesel from rapeseed oil (in Europe). Now, as global demand increases, companies are beginning to produce and sell biofuels in a number of geographies-and that's when things start to get tricky.

In many industries, the factors affecting returns vary geographically, and companies combine locations accordingly. With biofuels, these factors are particularly dynamic, often interconnected, and mostly uncertain. Two of them-feedstock costs and government regulation-are critical to any geographic strategy today, and conversion technologies will increasingly affect production costs as next- generation processes become commercialized. (Capital expenditures vary tremendously across regions, but no more so in biofuels than in any other industry.)

Feedstock costs and consequences

Feedstock accounts for 50 to 80 percent of biofuel production costs, so its price has a huge effect on the producers' returns. In the United States, for example, every dollar increase in the price of a bushel of corn raises the production cost of bioethanol by $0.35 a gallon and reduces the producer's operating margin by 20 percent.2 Many different forms of biomass can be used as feedstock, and costs vary hugely by region. Fermentable sugars from Brazil's sugarcane, for example, are less than half as expensive as those from European sugar beets. Government subsidies and alternative uses of feedstocks also affect feedstock costs.

In many regions, rising demand threatens both the cost and availability of feedstock. From 2003 to 2006, the percentage of the total US corn harvest used to produce biofuels rose to 16 percent, from 12 percent. But now that the federal government has adopted a goal of 35 billion gallons of alternative fuels a year by 2017, the use of domestic corn-based bioethanol to meet even half of this target would require 40 percent of that year's expected harvest. Not surprisingly, the cost of corn has soared: average wholesale prices rose from $1.90 a bushel in 2005 to $2.41 in 2006, and corn has regularly surpassed $4 a bushel on the spot market since late 2006.

Other unintended consequences of greater demand could bring a consumer backlash like the one that broke out in Mexico when tortilla prices skyrocketed because of bioethanol-related corn shortages. Environmental concerns were also raised after last autumn's burning of Indonesian forestland to make space for palm oil crops that were linked to increasing demand for biodiesel. The environmental impact of other aspects of biofuel production, including the widespread cultivation of fast-growing jatropha (a plant that produces a toxic vegetable oil), are unknown.

Government regulations

Whether through subsidies, import tariffs, or research grants, government regulation has helped drive both demand and profitability in the industry. Because the energy policies of most nations are still evolving, regulation is perhaps the greatest uncertainty of all. Lower subsidies, for example, could diminish profits. A production cost of about $2.90 a gallon and a government subsidy of $1.81 a gallon helped German producers to earn $0.42 for every gallon of biodiesel in 2006. The role of taxpayer money in creating new millionaires hardly went unnoticed, and the government decided to eliminate these subsidies, gradually, by 2012, replacing them with a mandated blend rate (the percentage of conventional fuel that blenders must replace with biofuel). Blend rates guarantee producers a certain level of sales, but the elimination of subsidies and the fact that supply will likely exceed mandated demand in the short term should depress margins. In such a market, companies generate attractive returns only when the cost curve is steep and lower-cost producers operate under the price umbrella established by marginal, high-cost producers. Since vegetable oil, itself a globally traded commodity, accounts for 80 percent of the production cost of biodiesel, the biodiesel cost curve isn't steep. Analogies with industries that have similar cost structures suggest that biodiesel margins could fall by 80 percent from 2006 levels.

The impact of mandated blend rates is also unclear. US regulators could set any ethanol blend rate from 10 percent (the maximum suitable for current vehicles) to 85 percent (the maximum suitable for most flex-fuel vehicles).3 Minnesota, for example, has mandated a 20 percent ethanol blend rate to take effect in 2013. What's more, mandated blend rates below 85 percent could be met either with the uniform blending of biofuels at the mandated rate or with a disproportionately high share of high-biofuel blends. All of these regimes would increase overall demand, but they could have vastly different effects on bioethanol companies and on other businesses, particularly car manufacturers. For now, car companies can keep selling vehicles with current engine designs, but some already plan to offer more flex-fuel vehicles, which use high-concentration biofuels, conventional fuels, or a mix of the two. Of course, the way carmakers deal with these issues will influence their other product-development decisions, especially for different low-carbon approaches, such as hybrid or hydrogen-fuel-cell cars.

Other policies are also in flux. With some exceptions,4 current biofuel regulations in the European Union and the United States protect domestic producers, but these policies-especially import tariffs-may change. Regulators increasingly recognize that current trade policy, which taxes imports of ethanol but not of petroleum, may not serve the goal of energy security. As evidence amasses confirming sugarcane ethanol's importance for reducing carbon emissions,5 regulators may ease restrictions on its importation.

The impact of new conversion technologies

New conversion technologies are going to cut overall production costs. Regional variations will either validate geographic strategies for biofuels-or turn them on their heads.

New conversion technologies are going to cut overall production costs; regional variations will either validate geo-graphic strategies for biofuels or turn them on their heads

Take, for example, bioethanol, produced when microorganisms such as yeast ferment sugars into ethanol. Next-generation technology will allow producers to use the sugars that make up cellulose (the main structural component of plants). Cellulose is found in all manner of vegetation, so cheap feedstocks-such as corn stover, sugarcane stalks (bagasse), and high-yield "energy crops" like switch- grass, energy cane (a relative of sugar cane), and wood-will become important feedstocks. The technology involves "pretreating" feedstocks physically or chemically and then using enzymes to digest the cellulosic components to release the fermentable sugars. For every step, competing technologies are under development.6 Each could lead to different production processes, biorefinery designs, and costs.

When this "lignocellulosic" technology becomes commercially viable-as early as 2010, by some estimates-the savings in costs and carbon emissions will vary by feedstock. Since feedstocks vary by region, their costs could change a region's attractiveness to producers. Consider these examples:

  • Today biofuel production in China is uncompetitive, because feedstock costs are relatively high. Cellulosic technology, however, could lower production costs to as little as $0.60 a gallon, from about $1.80, making Chinese bioethanol one of the world's cheapest biofuels.
  • In the United States and Brazil cellulosic ethanol production costs won't be much lower than today's corn- and sugarcane-based ethanol costs. Facilities processing cellulosic material thus will likely supplement rather than replace older ones, though cellulosic technology would have a significantly better energy balance when compared with the corn ethanol currently produced in the United States.
  • In Europe cellulosic technology could lower production costs enough to threaten companies producing beet (or wheat) ethanol with current methods.

Governments can help to advance technologies, but not without risk. In 2006 the government of Spain allocated $29 million to finance a joint Spanish- Argentine biodiesel research project. Likewise, the US Department of Energy recently announced $385 million in grants to six different cellulosic ethanol research projects. Technology could make it practical to use biobutanol, a molecule that outperforms ethanol as a premium gasoline replacement. Biodiesel, though far from cost competitive with regular diesel today, could in time be produced from jatropha, which provides a low-cost vegetable oil and can be cultivated on marginal land. Biomass-to-liquid (BTL) technology, a gasification process long used to convert coal into fuels, could eventually make it possible to produce high-quality synthetic diesel and gasoline. Most of these new technologies have yet to prove that they can be cost competitive. However, farsighted governments should avoid policies that favor today's technologies at the expense of tomorrow's.

Continued Next Week

Source: McKinsey & Co. 2007


  • Betting on Biofuels
  • Diners Invited to Rate and Review Salt Lake & Park City Restaurants
  • Economic notes
  • Eating out leads

    Bob Springmeyer

    Bonneville Research

  • Economic Notes:
    • Global business confidence
    • Global business confidence weakened a bit in early June, particularly in the U.S. This stands in contrast to other U.S. economic data released last week covering activity during the month of May, including stronger job growth and better manufacturing activity. While sentiment is still well above its low point very late last year, it continues to suggest that growth remains stuck at best at the low end of its potential. Pricing pressures also continue to spurt higher, as higher energy and other commodity prices are having an impact. Financial and business service firms and South American businesses are the most optimistic. Vehicle manufacturers, real estate firms, and European businesses are the least upbeat.
    • US Science graduate studies see revival in numbers
    • The number of US students going to graduate school for science and engineering hit an all-time high in 2005, offering a glimmer of hope to policymakers and business chiefs who have lamented that Americans are not interested in science.
    • Semiconductor Billings
    • In April, global semiconductor sales were valued at $19.92 billion on a three-month moving average basis, for a year-ago rise of 1.6%. On a month-ago basis, sales fell by 2.1% in April compared to March. On a month-ago basis, sales dragged in all areas except Japan, where sales held at $3.87 billion.
    • Productivity and Costs
    • As expected, productivity growth for the first quarter was revised much lower. Nonfarm business productivity grew 1.0% (SAAR), compared to 1.7% in the preliminary release. This revision was due to a much lower estimate of output. Growth in unit labor costs saw an enormous upward revision, from 0.6% (SAAR) to 1.8%; this was a bigger upward revision than the consensus expected. The larger-than- expected upward revision to unit labor costs will add to inflation concerns.
    • Wholesale Trade (MWTR)
    • Wholesale inventories rose 0.3% in April, in line with consensus estimates. March inventories got revised up to a 0.4% increase from the estimated 0.3% increase. Sales were strong again increasing by 1.3% following March's upward revision from 1.8% to 2.1%. The inventory-to-sales ratio fell lower again in April; it stands at 1.12 after being downwardly revised from 1.14 to 1.13 in March.
    • MBA Mortgage Applications Survey
    • Mortgage demand decreased 1.7% in the week ending June 1. Purchase applications increased 1.5% and refinance applications decreased 6.3%. Holiday seasonal adjustments have an impact, but generally the decline in the weekly index signals the market has little strength, considering recent trends that would increase the number of mortgage applications filed with MBA members.
    • Chain Store Sales
    • Chain store sales rose a modest 2.5% in May, well above April's revised 1.9% decline (previously - 2.4%), but only modestly above the March-April average of 2%. Sales were supported by improved weather while record gasoline prices were the biggest drag.
    • Wholesale Clubs and Drug Stores Lead May Sales
    • Wholesale clubs lead in May sales growth Wholesale clubs reported the most sales growth, at about 6.5%, according to the International Council of Shopping Center's index. Drug stores reported an average 5.3% sales increase for May, and department stores showed a 2.2% increase, while apparel chain store sales dropped by 0.6%.
    • Wal-Mart launches prepaid payment card
    • Wal-Mart will offer a Visa-branded prepaid payment card that will be issued by GE Money and will work almost anywhere Visa cards are accepted. The creation of the prepaid payment card is the next natural step for the company, which offers check- cashing and bill-paying services. It hopes that the new venture will appeal to customers without bank accounts.
    • Oil and Gas Inventories
    • Crude oil inventories rose by 0.1 million barrels for the week ending June 1, according to the Energy Information Administration, below expectations of a 0.3 million barrel build. Gasoline stocks surged by 3.5 million barrels, well above expectations of a 1.4 million barrel build. Refinery activity fell, but surging gasoline imports helped bridge the gap. Distillate inventories rose 1.9 million barrels, above expectations. This release will likely help put some bearish pressure on prices.
    • Challenger Report
    • Companies announced cuts affecting 71,115 workers in May. Cuts increased slightly over April and were one-third higher than in May 2007. Still, so far this year, cuts are 8.5% below the same period in 2006. In May, the computer industry led all others with 13,631 cuts. This was followed by automotive and government/non-profit.
    • Consumer Credit (G19)
    • Consumer credit increased in April by a modest $2.6 billion to $2.429 trillion. The details of the report showed that the latest jump in consumer credit was solely driven by a slight gain in nonrevolving credit, which increased 2.4% at an annual rate. In a bit of a surprise, revolving credit fell 0.5% at an annual rate.
    • Ford brands improve on vehicle quality
    • The quality of Ford Motor vehicles has improved markedly over the past year, according to JD Power and Associates' latest annual survey of North American design and production.The survey ranks Honda lowest overall among non-luxury brands.
    • Weekly Natural Gas Storage Report
    • Underground storage of natural gas increased by 110 billion cubic feet during the week ending June 1. This was slightly above expectation, which had called for a 107 bcf build. Inventories are now 20.4% above the five-year average. This report is likely to have a modestly bearish effect on prices.

    Source: Economy.com, ICSC SmartBrief & Financial Times

  • This Weeks Leads:
  • Food Leads:

    • Famous Famiglia
    • Famiglia - DeBartolo, LLC trades as Famous Famiglia at 63 locations throughout AZ, CA, FL, HI, IL, MA, MD, MI, MN, NC, NJ, NV, NY, OH, PA, TN, TX, VA and Washington, DC.
    • The pizzerias occupy spaces of 600 sq.ft. to 2,500 sq.ft. in entertainment, power, tourist and strip centers.
    • Plans call for 24 openings nationwide and in Mexico and China during the coming 18 months.
    • Typical leases run seven to 10 years.
    • A vanilla shell is required.
    • Preferred cotenants include McDonalds, Panda Express and Starbucks.
    • Competition is cited as Sbarro Pizza.
    • For more information, contact
      • Giorgio Kolaj,
      • Famiglia-DeBartolo, LLC,
      • 199 Main Street, 8th Floor,
      • White Plains, NY 10601;
      • Web site: www.famousfamiglia.com.
    • The Montana Mills Bread Company & Java Joe's Cafe
    • The Montana Mills Bread Company also doing business as Java Joe's Cafe operates 21 locations in NY and PA.
    • The bakeries occupy spaces of 1,200 sq.ft. to 2,700 sq.ft. in freestanding locations.
    • Plans call for 20 openings in the coming 18 months.
    • Expansion opportunities are sought in CT, NY, OH and PA.
    • The company prefers supermarkets, coffee shops, banks and post offices as cotenants.
    • Preferred demographics include a population of 50,000 residing in a three-mile radius earning an average annual household income of $60,000.
    • A vanilla box is required.
    • For more information contact
      • Richard Gunn,
      • Gunn Consulting,
      • 95 Highland Avenue,
      • Buffalo, NY 14222;
      • 716-885-8001;
      • Fax 716- 885-8002;
      • Web site: www.montanamills.com.
    • Krispy Kreme
    • Krispy Kreme Doughnut Corporation operates 177 locations nationwide and in Canada.
    • The donut stores occupy spaces of 4,000 sq.ft. to 5,000 sq.ft. in freestanding locations and power centers.
    • Expansion opportunities are sought across North America.
    • Preferred demographics include a population of 100,000 residing in a five-mile radius earning an average annual household income of $40,000.
    • The company is expanding both company-owned and franchised stores.
    • For more information contact
      • Steve Jones,
      • Krispy Kreme Doughnut Corporation,
      • 370 Knollwood Street, Suite 500,
      • Winston-Salem, NC 27103; 336-725-2981;
      • Fax 336-726-8253;
      • E- mail: sjones@krispykreme.com.
    • Bill Knapp's
    • Bill Knapp's Michigan, Inc. trades as Bill Knapp's at 49 locations in MI and OH.
    • The family-oriented restaurant occupy spaces of 4,500 sq.ft. to 5,600 sq.ft. in end cap and freestanding locations.
    • Expansion opportunities are sought in MI and OH. Leases running 10 to 15 years are typical.
    • For more information contact
      • John Bowman,
      • Bill Knapp's Michigan Inc.,
      • 110 Knapp Drive, Battle Creek, MI 49015;
      • 616-968- 1121;
      • Fax 616-964-0333.
    • American Cafe & Tia's Tex Mex
    • SRG Inc. trades as American Cafe and Tia's Tex Mex at 68 locations nationwide.
    • The American Cafe occupies spaces of 3,100 sq.ft. to 4,500 sq.ft. in regional centers and freestanding locations.
    • Expansion opportunities are sought nationwide except in CA, MO, ND, OR and SD.
    • Tia's Tex Mex occupies spaces of 4,200 sq.ft. to 6,000 sq.ft. in regional centers and freestanding locations.
    • Plans call for three to four openings in the coming 18 months and expansion opportunities are sought in the eastern U.S. and TX.
    • Preferred demographics include a population of 100,000 residing in a five-mile radius earning an average annual household income of $40,000.
    • For more information contact
      • James Carmichael,
      • SRG Inc.,
      • 150 West Church Street,
      • Maryville, TN 37801;
      • 865-379-5700;
      • Fax 865-379-6830.
    • Houlihan's and Darryl's Restaurant
    • Houlihan's Restaurant Group trades as Houlihan's and Darryl's Restaurant at 126 locations nationwide.
    • The restaurants occupy spaces of 5,200 sq.ft. to 7,200 sq.ft. in strip and specialty centers and freestanding locations.
    • Expansion opportunities are sought in St. Louis, MO; Kansas City, MO; KS; Chicago, IL; NY, NJ and Philadelphia, PA.
    • For more information contact
      • David Rockaway,
      • Houlihan's Restaurant Group,
      • 2 Brush Creek Boulevard,
      • Kansas City, MO 64112;
      • 816-756-2200;
      • Fax 816-751-8396.
    • Roadhouse Grill
    • National Retail Group of Florida trades as Roadhouse Grill at 83 locations in FL, GA, LA, MS, NC, NY, OH and SC.
    • The restaurants occupy spaces of 7,500 sq.ft. in mixed-use centers, end cap and freestanding locations.
    • Expansion opportunities are sought east of the Mississippi River especially upstate, east and central NY, southern OH and northern KY.
    • For more information contact
      • Mick Owens,
      • National Retail Group of Florida,
      • 6600 Andrews Avenue, Suite 160,
      • Fort Lauderdale,
      • FL 33309-2134;
      • 954-957-2600;
      • Fax 954- 969-5432.
    • Hartz Chicken Buffet
    • Hartz Chicken Buffet operates 42 locations in MS and TX.
    • The restaurants occupy spaces of 2,000 sq.ft. to 3,000 sq.ft. in strip and specialty centers and freestanding locations.
    • Expansion opportunities are sought in the existing markets.
    • For more information contact
      • Bill Knight,
      • Hartz Chicken Buffet,
      • 14451 Cornerstone Village, Suite 250,
      • Houston, TX 77014;
      • 281-583-0020;
      • Fax 281-580-3752.

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