China is Importing This (Surprising) Commodity at Record Levels

Here’s the story–and it could be a Big One–along with the trade to go with it.

Prior to 2015 China was basically importing no American ethanol–3.3 million gallons in 2014.

For the month the biggest importers of that US ethanol were:

It is hard to get clarity as to whether the increase in Chinese demand over the past two years is a short-term surge or part of a longer term trend.

China is the world’s third largest producer of ethanol after the United States and Brazil. The trouble that local producers have is that they rely on expensive domestic corn as their primary feedstock.

That can make U.S. and Brazilian ethanol a cheaper alternative if the cost of corn in China gets too high.

The Chinese Government over the past few months has bought up most of the domestic corn crop at high prices to support farmers. The Government then resells it locally at higher prices than are available globally.

That has made it hard for Chinese ethanol producers to turn a profit.

Fuel ethanol accounts for roughly one-third of all ethanol produced in China and more than half of the country’s consumption of industrial-grade ethanol.

Another long term plus could be the environmental movement which is picking up momentum in China. The Government has pledged to reduce carbon emissions and there are ethanol blend mandates in place in six Chinese provinces (Heilongjiang, Jilin, Liaoning, Anhui, Henan and Guangxi).

Those blend rates of 8-12% have room to increase given that Brazil has ethanol blend mandates of 27%.

So while China is doing good things for American ethanol producers in 2016, it could do even better things going forward. There are no guarantees though, especially given how committed the Chinese Government is to the electric car as being the solution.

The large Chinese exports have caused a (very positive) domino effect in the US ethanol market. Consider this:

1) As a result, inventories are dropping and profit margins are now good and seasonally get stronger through the end of Q3 from here

2) RIN prices are strong.

Here’s what ethanol inventories are doing–the orange line in the chart below shows ethanol inventories coming down from all-time highs into the 5 year band…still not great but showing the right direction: down.

Now with RINs….ethanol that gets exported does not get a RIN attached to it. What’s a RIN you ask? Only one of the most arcane and befuddling economic inventions known to man. The US government mandates that every single gallon of ethanol used in the US has a Renewable Identification Number attached to it, and the refiners have to keep track of them to prove they are using 10% ethanol–which they are required to do by law. (I don’t make or judge the rules, I just try to profit from them…)

Monthly gross generation through Q1 2016 has averaged 1.224 billion RINs, suggesting total generation for the year will reach just over 14.7 billion RINs. This exceeds the 14.5 billion gallon portion of the overall RFS mandate (Renewa le Fuel Standard) which can be met using ethanol or ‘D6’ RINs.

The way to invest in this trade is to (obviously) buy the pure play ethanol producers.

Now, I’m going to paint a somewhat positive picture here, but readers should remember–this trade will go where oil goes. If oil drops $5/b from here, the trade I’m about to tell you will go lower. AND…as I’ll explain the Street would have to give the stock a higher multiple than 5…on my optimistic economics…to go a lot higher. Hence I’ve only bought 5000 shares for now.

Ethanol producers are refiners; oil refiners have a crack spread (the price difference between the crude oil and the gasoline it produces; expressed in dollars per gallon) and ethanol producers have a crush spread (the difference between corn costs and ethanol sales). The crush spread is the profit per gallon.

The two charts immediately below show, respectively, the Midwest crush spread and the West Coast crush spread:

Midwest Crush spread below

West Coast crush spread below:

As you can see, Midwest margins have improved considerably. And between a juicy increase in gasoline consumption and an even better jump in ethanol exports, I think these margins are here to stay for a couple quarters.

Here’s a chart of the seasonality of ethanol profitability:

(The impact on GPRE’s earnings will still be positive, but less certain due to their reliance on ethanol futures rather than spot prices.)

PEIX was originally a west coast producer, but after it bought Aventine last year it now has 45% of 515 million gallons of its production capacity in the Midwest.

PEIX is a highly levered company, in a couple senses of the word. There is only 43.2 million shares out for 515 million gallons of annual production. Low share count=leverage. A $0.20 increase in ethanol production margins from Q1 to Q2–which has now happened–on 120 million (likely) gallons of production would make for a Q2 EBITDA of ~$24 million – a meaningful amount for a company with a $410 million Enterprise Value (on the day I bought the stock two weeks ago at $4.95).

Consensus EBITDA estimates for the year is $58.29 million. If the oil price stays steady here, that will go up for sure–there is a chance they could do close to that in Q2 and Q3 combined. Be aware that a 5x EBITDA on $80 million EBITDA puts the stock at $5. The Street would have to give the stock a higher multiple for this trade to give me the 50% I like to see in all my trades.

Leverage can also be debt. At the end of Q1, PEIX only had $19 million cash and had $210 million debt, after paying down $17 million in debt to make its western plants debt free. They are trying to re-finance that debt, and analysts estimate they could shave 300 bps on their interest. One analyst noted they could sell one of their Midwest plants and be debt free. Just over $140 million of that $210 million is term debt due the end of September 2017, though it is due at the Aventine plant level, not the corporate level.

One of the issues for me is that management hasn’t given much clarity around the midwest Aventine acquisition assets; they remain a bit of a black box and are a small wild card in quarterly reports. They had no money spent on them for 3-4 years before PEIX bought them.

Add an activist shareholder (Candlewood) with a 25.8% stake who has said they want asset sales or some kind of restructuring to unlock shareholder value–and maybe the Market gets excited.

I hope I have laid out the positives and negatives of this trade. In my corner I’ve got strong gasoline demand domestically and big China export demand. Seasonality should favour me as well. In the other corner is lower oil prices, less discipline by ethanol producers and new licenses for more ethanol plants in the US.

One other positive is the stock chart–it has just broken out.

I got very lucky with the timing of the trade–the stock jumped $1/share the next day. But if China keeps up its strong imports of US ethanol–which could have a big impact on air quality in the cities that use it–ethanol could become a Big Trade again.

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