WASHINGTON - As soaring oil prices renew public interest in alternative fuels, at least three bond issuers are considering tax-exempt financing for manufacturing facilities that would make fuel-grade and industrial-grade ethanol.
But while the work has begun, it is not clear if the deals will ever see the light of day because of uncertainties about the technology that would produce the gasoline additive, the demand for it in the market, and whether Congress will retain the critical tax subsidy for fuel-ethanol producers, which allows them to sell their product at prices that are below its production costs.
That subsidy, enacted in 1978, is one of the few remaining vestiges of the United States' energy policy during the last oil shock, when federal efforts to encourage energy conservation and develop alternative fuel sources peaked. But as oil supplies surged and prices fell in the two decades since, observers say conservation efforts have largely subsided, and the alternative energy sources were often unable to compete on economic terms.
Currently there are about 50 plants throughout the country that make fuel-grade and industrial-grade ethanol. All have been financed by private corporations or by nonprofit farmers' grain cooperatives, said Stephen Brinkman, a managing director with ABN AMRO Inc. in Chicago.
NEW TECHNOLOGY, NEW FINANCING
But the development of new technology that integrates ethanol production with solid-waste disposal is opening the door for sponsors to use tax-exempt private-activity bonds to fund new plants.
The product itself, also called ethyl alcohol, can be used as a gasoline additive or in the manufacture of consumer goods including perfumes, cosmetics, and hairsprays.
Ethanol can be made from agricultural products, including corn and other grains and cheese whey, or other renewable resources, including residue and waste generated from the production, processing, and marketing of agricultural and forest products.
The most popular use for ethanol is as a gasoline additive. Fuel-ethanol production outpaces industrial-ethanol production by a margin of about six to one. U.S. producers are expecting to manufacture as much as 1.7 billion gallons of fuel ethanol this year, up from about 1.47 billion gallons in 1999, according to the American Coalition for Ethanol. And if gasoline prices continue to climb, production levels are likely to rise, as well.
Masada OxyNol believes it can fill a niche in that expanding market with a $250 million plant in Middletown, N.Y., that would produce fuel ethanol and industrial-grade carbon dioxide from municipal solid waste and sewage sludge using the company's patented CES OxyNol process. The plant would also sort, separate, and sell recyclable materials from the waste stream, including glass, plastics, and metals. Tax-exempt bonds are among the financing options being considered.
On the industrial side, Chemical Strategies, a Sleepy Hollow, N.Y.-based consulting firm, estimates that about 270 million gallons will be produced.
That is the market being targeted by Boston-based BC International Corp., which earlier this year received approval from the Louisiana State Bond Commission to sell a maximum of $120 million in revenue bonds through the Louisiana Public Facilities Authority to pay for an industrial-ethanol plant near Jennings. Goldman, Sachs & Co. and Lehman Brothers are slated to co-manage the issue.
But the economics of all of the deals give some investors pause. The Louisiana issue was expected to sell last spring, but has been on hold as underwriters work to drum up more buy-side interest.
Issuers are also proceeding cautiously. The Oregon Office of Energy, which sells general obligation bonds backed by the full faith and credit of the state, has given preliminary approval to a $15 million GO issue to partially finance a facility that would produce fuel ethanol out of grain, according to Larry Gray, an administrator in the energy loan division. The plant would be built and run by Cascade Grain Products of Federal Way, Wash., and the bonds would be issued by the Treasurer of the State of Oregon on behalf of the Oregon Office of Energy, which is a stand-alone state agency, Gray said.
Gray added that he understands construction costs for the project are currently estimated at $171.5 million, in addition to the $58 million need to cover financing and other costs, for a total of nearly $230 million. But Gray said the sale is contingent on the developer being able to prove that it can raise the remainder of the financing and operate the plant profitably.
In order to be approved, the borrower has to be deemed creditworthy and have sound management, he said, and in addition, the loan has to be secured. Moreover, his office has to be satisfied that the project is a viable business proposition and the energy technology to be used is in fact feasible, he said.
Whether the deal is approved "depends on our assessment of the project and what they've done to mitigate the risk," Gray said, adding that Cascade has provided a partial business plan and has committed to answering a few remaining questions. He added that he understands that the company is looking for substantial additional debt and equity from other sources.
Cascade's vice president and chief financial officer, John Pena, did not return calls seeking comment on the status of the deal.
Masada OxyNol has also run into roadblocks. It dropped a plan to build a $250 million garbage-to-ethanol facility on a landfill site in its hometown of Birmingham, Ala., after the City Council voted to delay consideration of the project until a regional solid-waste authority was established.
WHO'S WILLING TO BE FIRST?
The questions about the commercial viability of the relatively new garbage-to-ethanol manufacturing process are loudest for the Middletown plant, which is being touted as the first of its kind in the world.
David Morris, vice president of the Institute for Local Self-Reliance, performed a technology review of the proposal in 1996 at the request of Al Fusco, Middletown's public works commissioner. Morris said the proposed plant, which he described as a "strange beast, halfway between a garbage incinerator and an ethanol plant," should work.
Fusco confirmed an earlier report from Bloomberg News that Middletown and 20 other cities and towns in Orange County, N.Y., have signed a 20-year contract with Masada OxyNol, in which the company agreed to build the Orange Recycling and Ethanol Production Facility in Middletown. Masada and Fusco have declined to discuss the financial terms of their agreement and how they plan to overcome the various risks involved.
But at its heart, the proposal would rely on the successful, profitable operation of the plant. And while the technology is new, Masada officials have said it is proven, and Morris agreed that it could work.
From an economic standpoint, Morris argues that the beauty of the plant, which would make ethanol and other products, is that it would be able to rely on revenue streams in addition to revenues from ethanol sales.
In exchange for accepting nearby municipalities' garbage, the plant would take in recycling revenues along with the customary "tipping" fees that run from $65 to $70 per ton, Morris said. Orange County officials said their current garbage-disposal tipping fee is $65 per ton, so the new plant would be competitive.
But while the potential revenue streams are diverse, they are all still subject to market forces. Peter Rigby, an energy project analyst with Standard & Poor's, said that while many garbage-to-energy deals have generated a lot of money form tipping fees, the plants' rates have to be competitive with other disposal sites, such as landfills or traditional incinerators, in order to attract business. The prices of ethanol and raw recyclables also have histories of fluctuating widely.
ABN AMRO's Brinkman, one of the few investment bankers who has delved into the financing of ethanol projects, said he would be reluctant to invest in this particular deal.
"I'm not picking on the Middletown technology, but if it's a new technology, you don't quite know what you're going to encounter," Brinkman said. "It's not like you can go on a due diligence inspection and look at four other plants and say: 'this is how we do it, put corn in and we get ethanol out.' "
DIFFERENT BACKGROUNDS, DIFFERENT PERSPECTIVES
If and when underwriters begin marketing the bonds, the diverse mix of revenue streams mean they will have a complex story to tell.
The plant's ethanol-generating capacity is so limited that it will need revenue contributions from other sources -- especially the tipping fees -- to cover its debt service. That means potential investors who are used to self-sustaining ethanol plants will have to become more comfortable with the vagaries of the municipal solid-waste disposal sector, and municipal solid-waste investors will need to learn more about the ethanol industry.
Rigby, a project finance analyst who has analyzed solid-waste deals, pointed out that there is a risk that the plant would have trouble selling its products.
"There aren't that many entities out there that are willing to sign long-term contracts to buy ethanol, particularly at some fixed price, or even at an escalating price," Rigby said. "Depending on what there is that's surrounding to wrap the risk, it could be conceivably more risky than the average power transaction or waste-to-energy conversion transaction because you're selling a commodity."
Meanwhile, Brinkman, who has been involved in ethanol deals with farmers' grain co-ops that used taxable private notes that were privately placed, expressed concern about whether the ethanol could be sold at a price high enough to service the project's debt.
"We've never been successful in getting a strict offtake agreement that says: 'We're going to buy your ethanol for X money' or 'we're going to basically guarantee the project,' " he said. And such a plant would also face stiff competition from gigantic established, profitable ethanol producers that finance privately, such as Archer Daniels Midland Co., so making money on the deal would be less than certain, Brinkman said.
James Evangelow, who did consulting work for Masada OxyNol, said the $250 million facility's prospects are not terribly rosy, largely because the project is really just a recycling plant that makes ethanol as one of its products.
Evangelow, a chemical-commodity consultant with Chemical Strategies who specializes in ethanol-related business planning, said the plant, which is supposed to make nine million gallons of ethanol per year, is simply not economically viable on that basis alone.
"You would never, never spend that kind of money to make nine million gallons of ethanol," he said. A rough rule of thumb is that on smaller plants, which lack the economies of scale that larger plants enjoy, capitalization should be equal to about $1.50 per gallon produced, he said.
Using Evangelow's formula, the investment in the Middletown plant ought to be closer to $25 million.
Kalyn Chapman, public information manager for Masada OxyNol said a confidential agreement between the company and Middletown prevented her from discussing specific details of the project such as its planned tipping fees, but that the planned facility is "indisputably attractive to the bond market."
SIMPLER PURPOSE = LESS RISK?
Participants involved in financing the Louisiana industrial-grade ethanol plant have said the project is a good risk.
The market for industrial ethanol enjoys greater price stability and higher profit margins than the much larger fuel-ethanol market, according to Jill Toporek, a vice president at Goldman Sachs, the Louisiana deal's co-manager.
Moreover, the industrial-ethanol market does not have political risk because it does not rely for its continued existence on a tax subsidy from Congress, Toporek said.
Stephen J. Gatto, chairman and chief executive officer of BC International, the project's developer, pointed out that high-quality feedstock for use in making ethanol is very easy to find near the proposed Jennings site. The feedstock, bagasse -- which is the dry, leftover part of sugar cane after the juice has been extracted -- is in abundant supply there, he said.
But the Louisiana deal is moving slowly.
The Bond Buyer reported in February that Louisiana Public Facilities Authority president and CEO Jim Parks said at that time that the authority expected to privately place the private-activity bonds with institutional investors within four to five weeks.
Parks said in a recent interview that the underwriters were having difficulty finding investors, and none of the parties involved in the Louisiana deal were able to say when they expected the bonds to go to market.
Asked to comment, Steve Howard, a senior vice president with co-manager Lehman Brothers, said a funding deal has not yet been reached with various bond funds, but that the parties are engaged in negotiations. Toporek added that more equity has been raised than originally expected, so probably only about $90 million in bonds will actually be sold.
In an apparent attempt to make investors more comfortable, the Louisiana project's sponsors are exploring receiving a rating for the bonds. Dan Stone, a director at Standard & Poor's, recently confirmed that his agency had been asked to examine the Louisiana deal.
WASHINGTON: HELP OR HARM?
Because of the importance of the fuel-ethanol tax subsidy to the industry, as well as the role the Environmental Protection Agency plays in encouraging ethanol use as part of clean-air programs, backers of the deals are watching Washington closely for any change in the status quo.
Starting in 1990, the EPA began requiring states that were experiencing severe air-pollution problems to increase the oxygen content of the gasoline sold within their borders. Currently, only ethanol and methyl tertiary butyl ether are used to achieve that result.
But MTBE that leaked from underground tanks at gas stations is suspected of contaminating some groundwater supplies, and the EPA is considering whether it should ban that additive altogether, a move that could more than double the demand for ethanol.
On a more fundamental level, however, California, one of the nation's largest markets for the so-called reformulated gasoline is asking the EPA to exempt its gas dealers from the oxygenation requirement. A decision on that request is pending.
Meanwhile, the fear that a future Congress might repeal the fuel-ethanol tax subsidy also hovers over the market.
Currently, alcohol fuel blends of 10% ethanol and 90% gasoline qualify for a 5.4-cent exemption from the 18.4-cent per gallon excise tax on gasoline. In addition, there is a small ethanol producers' credit of 10 cents per gallon, a tax deduction available for alcohol-fueled vehicles, and a tax credit for the production of unconventional fuels, according to the Congressional Research Service.
House Ways and Means Committee chairman Bill Archer, R-Tex., pushed unsuccessfully for a repeal of the tax break in 1997, but the program appears to enjoy rock-solid support from a majority of the members of Congress. When Congress extended the program two years ago to 2008, the House vote in favor of so doing was 297 to 86, and the Senate vote was 88 to 5, reflecting lawmakers' near-unanimity on the issue. And with Archer set to retire this year, the chief antagonist will soon be gone.
"Ethanol has strong support in Congress because it is important to the agricultural economy, particularly in the Midwest," one aide to a Midwestern senator said in an interview.
Consultant Evangelow agreed with that sentiment.
"The real driving force is agriculture, overproduction of agriculture, utilization of excess production," he said. "You have about 600 million bushels of corn per year going into ethanol production ... at a time when agricultural surpluses continue to mount, what is the likelihood that Congress will kill the subsidy ?"
The market for the product is likely to continue growing, leading to a need for more production facilities, Evangelow said.
"The amount of risk continues to diminish daily," he concluded.
