The Song That Never Ends: the financing of Cellulosic Ethanol

“This is the song that never ends, it goes on and on my friends, some people started singing it, not knowing what it was, and they continued singing it forever just because this is the song that never ends, it goes on and on my friends…”

It was the day upon which the secret of financing cellulosic ethanol was to be revealed. All the industry leaders gathered at the Department of Energy. A speaker emerged from inside a deep, deep fog. “I have the answer to all your problems,” he said to the listeners. They leaned forward, and he began he telling of his tale:

“It was the day upon which the secret of financing cellulosic ethanol was to be revealed. All the industry leaders gathered at the Department of Energy. A speaker emerged from inside a deep, deep fog. “I have the answer to all your problems,” he said to the listeners. They leaned forward, and he began the telling of his tale: It was the day…”

By now, you know that you are reading what is known in children’s songs, computer programming, and the financing of cellulosic ethanol as the Infinite Loop.

This is a condition in which paradox prevents the arrival of circumstances by which the song, the routine, or the financing effort will ever end. Parents who have suffered through endless choruses of “This is the Song That Never Ends,” “I found a Peanut,” or “There’s a Hole in my Bucket” will know the paradox well.

So too do cellulosic ethanol developers.

The Loop

The Infinite Loop in financing cellulosic ethanol is the setting of conditions for loan guarantees by the Department of Energy which cannot be fulfilled; the insistence of project financiers that, without loan guarantees, project financing will not be forthcoming, and the insistence of strategic investors that project finance is a necessary component of taking projects to scale.

The paradox – “I will give you money if no one gives you money”

Contemplating the logical tangle of “I will give you money if no one gives you money,” is a pleasant diversion, if you are reading about paradox in the pages of Godel, Escher, Bach or I am a Strange Loop.

In contemplating he stand-off between the US government and obligated blenders over who is going to assume the risk and put up the money for renewable fuels, it is less pleasant, though certainly a diversion.

What is it diverting us from? A world beyond fossil oils, and the downside of “drill, baby, drill”.

But what appears to have escaped congressional overseers is the infinite loop that has been created and, like a paradox, is impossible to resolve without restructuring.

In cellulosic ethanol, the conditions for DOE loan guarantees are: a long term, fixed price feedstock contact from a credit worthy supplier and a long-term, fixed-price for fuel from a credit-worthy offtake partner.

It sounds reasonable enough – after all, debt is cheap compared to equity, banks make pennies on the spread between interbank borrowing and project lending rates and it is reasonable to reduce risk as close to zero as possible.

That’s why project finance sets those conditions. In the world of renewable power, they are easier to obtain, as 20-year, fixed-price power purchase agreements have been struck for years with utilities by independent power producers. Plus, solar and wind projects do not have the requirement of buying feedstocks from growers.

But fuel is a different animal altogether. No one knows the forward prices of commodities, and price stability is assured through hedging rather than fixed prices. Fuel hedging, as practiced for example by Southwest Airlines, involves a mix of swaps and call options that are not available in ethanol trading. They are certainly not available in emerging ethanol feedstock markets such as switchgrass, miscanthus, jatropha, or timber slash.

The urgency

Driving urgency in the financing of cellulosic ethanol is not only the general desire of projects to move forward, and the country to have more renewable energy options on the table in a post-BP world. There’s also the problem of the money running out.

In Recovery Act funding — which are real, available, appropriated dollars — funds which are not spent or committed by September 30, 2010 will be returned to the US Treasury. So, recipients of grants are in an awful hurry to get their projects approved and funded by DOE.

That’s easier for Integrated Bioenergy plants which are proceeding to the pilot or demo stage where funds are typically covered by strategic investors, VC and the DOE grants.

For commercial-scale projects — such as cellulosic ethanol plays — that brings us back to the debt component and the Infinite Loop in project financing. Only now, there are severe time pressures.

Mitigating factors

It is not that grant recipients lose their grants on September 30, 2010 if they are not funded and starting on construction. The risk is that the some (or the majority of) grant funds will no longer be funded by Recovery Act dollars, and Congress will have to make a new appropriation to fund them. Risky, time-consuming – could be 2011, could be 2012.

For sure, USDA loan guarantees are easier in terms of the conditions, but they have their own problems, which have been essayed by the Digest in the past. Primarily, requirements that banks make the applications for grants (generally limiting the field to smaller ag banks that are comfortable with the process but lack the capital for large-scale financing), and ceiling of 60 percent on loan guarantees of more than $100 million and a requirement that originating banks retain 20 percent of their loan.

That latter condition, in a $300 million cellulosic ethanol project, can leave banks with as much as $80 million not covered by loan guarantees – and tough rules limiting syndication.

For sure, Range Fuels received a loan guarantee out of the DOE process, but according to reports by those familiar with the deal, “deep pocketed” investors were required to make personal guarantees in order to move that project forward.

For sure, Mintz Levin, Kreig DeVault and Stern Brothers have developed a bond-based approach to financing bioenergy projects, but it requires USDA acceptance and, with September 30th looming, there is a good chance that such a program, if greenlighted, would come to late to enable projects to tap fully-funded Recovery Act grant money, and lead to further delays into 2011-12 before projects can commence construction.

Fixing the hole in the bucket, dear Liza, dear Liza

Congressional action is reportedly forthcoming to “fix” the Renewable Fuel Standard and the rules for issuing loan guarantees. But there are a raft-full of issues (feedstock and fuel neutrality, the obligation of EPA to enforce mandates, the nature of loan guarantees), and the energy bill will not only cover biofuels, but all renewables, and quite possibly a broader set of energy issues.

An energy bill to take care of all the energy issues in the post-BP world — even if passed — is no certainty for this year and is rated zero-chance for passage by the end of the summer by those familiar with the timing.

So we return to a theme that will be heard more and more as the summer draws out from renewable fuels developers: “EPA, enforce the mandate.” The 2011 mandate is 250 million gallons of cellulosic biofuel, 500 million gallons in 2012, and 1 billion gallons in 2013. Absent supply, EPA has options to create the equivalent of buyout options for oil companies who cannot find the cellulosic ethanol to blend.

Should the EPA waive down the cellulosic biofuel component to 20-30 million gallons, it will have matched supply to demand but in no way will have used the regulatory power of the agency to force the development of renewable fuels. It simply will be mandating what the market would have created on its own. But were the mandate to be enforced, and buyouts set at $5 per gallon (to pick a figure out of thin air), blenders facing $8.25 billion in buyout costs may well start to look at the option of financing cellulosic biofuels off the balance sheet in a whole new light.

Foot-dragging in the happy halls of oil almighty?

Digest sources have repeatedly confirmed foot-dragging on the part of oil companies in terms of financing advanced biofuels off their balance sheets.

To which we ask: Why wouldn’t they drag their feet? Wouldn’t you?

First of all, oil companies don’t care much for ethanol. Second, they care less for mandates. Third, they have more lucrative investments available to them. Foot-dragging has the potential impact of making ethanol mandates go away – especially when EPA follows up the non-spending with non-enforcement.

“Ethanol going away”.  A scenario not known to cause severe indigestion amongst the nabobs crowding the lunch tables in Houston or Riyadh.

Q: Where is Archer Daniels Midland — which has a strong balance sheet and (shhh) likes ethanol?
A: Investing in other, more lucrative projects, too. No blending obligation on ADM.

Mandates: fair measues or war measures?

All of which brings us back to the mandate in the Renewable Fuel Standard. Should it be enforced – and what would happen if it were?

Is enforcing a mandate in the absence of supply a fair measure? Resoundingly, no. It is a war measure. The question is whether energy is a problem that requires war conditions.

Fair? Humbug! It’s a tax on the oil industry. One likely to be hugely unpopular with the friends of fossil oil.

Is the country in a mood for punitive taxes on oil companies and refiners to force them towards investment in renewable fuels? If ever they were, now is the hour.

Is it the right choice? That’s for EPA and their overseers to decide. As White House Chief of Staff Rahm Emanuel has said, “Rule number one: never let a serious crisis go to waste.”

Door #2: the reverse auction

Another alternative, a reverse auction for $800 million in US government debt, based on a standard number of gallons (say 50 million gallons), a demonstration of technology (or waiver from DOE’s engineers, based on pilot project data) required prior to bid, 20 percent equity contribution, 30-year repayment timetables, 24-month construction maximum, standard interest rate, and a minimum low carbon standard.

Each project bids to meet the required standard and the lowest bid that clears the market is accepted for all bidders. Start that by year end, you have perhaps 200-300 million gallons of capacity – enough to conceptually meet the mandate, and establish the track record for projects that will 0pen up conventional capital markets.

Door #3: Finance government loan guarantees

The DOE says that its issues in financing cellulosic ethanol related to protecting the US taxpayer. So, why not announce a funding round, to fund the US loan guarantee reserves? If the US, for example, would like to issue $2 billion in biofuels loan guarantees but can’t (or won’t) finance a 10-15 percent reserve fund for project defaults, preferring to fund a reserve in the 2-3 percent range that makes advanced biofuels too risky to fit, why not create a privately funded reserve covering the, say, $240 million gap.

Bidders for the bonds have the default risk, and are paid interest by the projects who receive the loan guarantees.

Whatever the fix, as country singer June Carter Cash put it, “Time’s a Wastin” – and there’s no better time to put the infinite loop in renewable fuels financing out of business, then now.