US ethanol producers should be celebrating. The country's president-elect, Barack Obama, made explicit, and near cast-iron, promises to support the fuel during his attempts to win the Iowa caucus. The price of corn, the primary ethanol feedstock, is down from is mid-2008 peak. The price of natural gas, a secondary feedstock, has remained low.

But the industry has faced a rash of bankruptcies and downgrades. The most spectacular of them, VeraSun Energy, has dragged several project financings into its chapter 11 bankruptcy proceedings. VeraSun and its 24 subsidiaries filed for bankruptcy protection on 31 October, following its inability to cope with unfavourable movements in corn prices.

VeraSun's fall

VeraSun had 15 plants in operation, and one under construction, and with the completion of the final plant would have had production capacity of 1.64 billion gallons per year. At the end of September 2008 it was the subject of almost $1.6 billion in debt, including $547 million in senior notes ($437 million with a 2017 maturity and 9.375% coupon, and $210 million with a 9.875% coupon and 2012 maturity), $266 million project debt led by WestLB, $109 million in borrowing base debt from UBS and nearly $260 million in debt from AgStar Financial.

VeraSun had hoped to get debtor-in-possession financing in place as soon as possible, but the supply of such debt has become limited, and VeraSun suffers from high existing amounts of secured debt and assets that include volatile commodities inventories. It gained approval on 4 December for $196.6 million in debtor-in-possession financing from existing lenders.

Leaning on existing lenders for assistance, and their acquiescence, highlights the stake that they have in borrowers making it through the current environment. In January 2005 WestLB arranged $275 billion in debt for ASAlliances' three plants, which were then sold to VeraSun by the portfolio's private equity owners in May 2007. WestLB has had to kick in $10 million in DIP funding, and consent to a later infusion of another $10 million.

AgStar, a farm credit association, has an even larger exposure. It provided $15 million on an interim basis shortly after the filing, a sum that was increased at the final DIP approval to $24.5 million. AgStar led the $427 million financing of the US BioEnergy portfolio in February 2007, a portfolio that VeraSun acquired earlier in 2008.

AgStar's becoming ensnared in VeraSun's bankruptcy is notable, since agricultural lenders, which pride themselves on roots in the areas where ethanol production is located, were best placed to see the ethanol industry's difficulties coming. AgStar was also the construction lender to the Beatrice biodiesel project, whose Australian developer put the project into liquidation in September.

Who's to blame?

Struggling ethanol producers tend to blame their difficulties on general market conditions, and the difficulties faced by other project operators with commodities exposure in power and oil and gas support their complaints. But ethanol faces two much larger difficulties: the exhaustion of the mandate on which producers rely, and hedging markets that are inadequate for long-term debt financings.

VeraSun illustrates the second problem best. It is believed to have locked in prices for its corn feedstock at roughly $7 per bushel earlier this year, as prices rose to nearer $8. When prices fell to below $5, VeraSun was committed to much higher-priced corn purchases, even as ethanol prices made it uncompetitive to produce at such feedstock prices. VeraSun has been successful in rejecting some of its corn purchase agreements, one of the main factors in its decision to file for chapter 11, though leaving bankruptcy will depend on it gaining a more robust long-term debt package. Farmer-owned Pine Lake Corn Processors recently shut off production after suffering from a similar hedging strategy.

But VeraSun's problem was also a more familiar one – high leverage and poor operating margins. It had financed its acquisition binge with corporate level debt, even as these assets came with their own project-level debt. Without the gyrations in the ethanol market, project lenders might have sat the proceedings out unscathed.

VeraSun has said that it received an unsolicited expression of interest in buying out its facilities, although it did not mention a price or indicate whether debt providers would be made whole from the purchase. Market speculation about the buyers' identity has focused on POET, an integrated, privately-held ethanol producer that has weathered the market in much better shape than its competitors. POET has 26 plants, and attracts admiring mentions from bankers and lawyers active in the market.

But some standalone producers might be able to keep afloat, particularly those that make luckier hedging calls. Aventine Renewable Energy, a producer started by former Morgan Stanley private equity specialists, recorded slight gains from its corn hedging activities. Still, Aventine has delayed completion of its Aurora, Nebraska plant because of poor market conditions, and Standard & Poor's recently downgraded its $300 million in bond debt to B. It also lost $30 million as a result of parking some cash in distressed auction rate securities, which it has subsequently sold.

Aventine still has some overhanging commitments from the boom years. It can only delay, and not abandon, Aurora because of its agreement with the Aurora Cooperative of corn producers, which specifies liquidated damages of up to $5 million if the plant is not online by 1 July 2009. It has to have 110 million gallons online at Mt Vernon, Indiana, by the start of March 2009, and another 110 million online by the first day of 2011, or risk the Indiana Port Commission taking over the project.

Construction crunch

In late 2007, construction contractors for ethanol projects were already reporting an increased number of available construction slots. Fagen, the largest and most experienced contractor, was choosy about the projects it took on.
Plants located away from US corn-producing regions, and those using non-standard processes, needed to turn to other contractors. Germany-based Lurgi, now part of Air Liquide, held the fixed-price engineering, procurement and construction contracts for two such plants: Panda Ethanol's manure-fired ethanol plant, and Northeast Biofuels' Fulton facility, located at a former brewery in New York state.

Both plants have suffered from construction delays, which have necessitated negotiations with debt-holders, and sparked debt downgrades. The Notheast Biofuels (NEB) Fulton plant was meant to reach substantial completion on 31 October, and is now in testing, but the date for its handover to the owner is now set for 9 January 2009.
NEB closed a $217 million construction financing in June 2006 with Goldman Sachs, which was set to benefit from a crush-spread hedge, also with Goldman Sachs. The hedge would have protected the project's margin between ethanol prices and corn prices, but was first amended and then dropped in July when the delay to the plant's completion became apparent.

The hedge attracted some scepticism, with one rival arranger noting that the hedge would have capped the ability of the plant to profit from spikes in prices. As it turns out, the ethanol boom ended even quicker than the plant could enter operations. "The project actually would have benefited from the hedge had it still been around," remarks one lawyer familiar with the project.

Instead, as Moody's noted upon downgrading NEB's debt from B2 to Ca1, the project has eaten through both its debt service reserve and working capital facilities, and has kept lenders whole by issuing them with payment in kind – more debt. The construction contract, according to an S&P report on the deal, specifies liquidated damages up to a cap of $7.5 million, but the project has already paid out most of the contract price to Lurgi.

Panda Ethanol's dispute with Lurgi is already in full swing. The sponsor and contractor have filed lawsuits against each other over the delays. Since 2007, Lurgi has claimed that labour shortages, weather conditions and, at one time, an outbreak of a cattle-borne disease, constitute force majeure events that permit a renegotiation of the contract. Panda has terminated the EPC contract and withheld liquidated damages from its payments to Lurgi.

During this period, Panda amended the $160 million financing agreement with its SG-led banking group in April 2008, and then obtained five waivers in September and October. Panda has contributed additional equity to meet the project's estimated $269 million cost, and has also closed small senior and subordinated debt financings. Both Lurgi and Panda now predict that the plant, which is 98% complete, and is fired using manure from nearby cattle farms, can be complete before the end of the first quarter of 2009.

The dispute has echoes of the disputes between sponsors and contractors that characterised the aftermath of the collapse in the US power market, although none of the ethanol projects' contractors have gone bankrupt, as their counterparts in power did. "At the moment, the claims and counterclaims are all about gaining an edge in litigation," suggests one observer. "These disputes can often be a way of resetting the EPC price to a more realistic level."

Hitting the wall

But the price of ethanol has now settled well below the price of petrol, because the federal mandate that has supported construction of new facilities is now exhausted. US refiners must blend 9 billion gallons of ethanol in 2008 and 10.5 billion in 2009, and the US ethanol industry now has more than enough production capacity to meet these. High corn prices encouraged politicians to consider reducing these mandates.

Unless a refiner needs, usually for logistical reasons, to lock in a supply of ethanol, and is prepared to buy a plant or sign a tolling agreement for that supply, plants will have to operate as price-takers. "Lenders will need to come along for the ride, and will probably need to help producers increase their access to working capital," says a banker active in the market.
Cellulosic ethanol offers the best hope of consistent margins, mostly because the feedstock – wood, grasses and other plants – is much cheaper than corn. But while the technology has had some success so far, it has not been proven to a degree that would satisfy a project lender. One of the nearest developers to market, Raven Biofuels, is looking for $30 million to fund an 11 million gallons-per-year plant that would run on wood waste. It has so far brought in $10 million in equity, from Blackhawk Investments and Clean Energy Holding.