Pacific Ethanol: Creative crusher

Pacific Ethanol, the largest West Coast-based marketer and producer of ethanol, closed a $325 million project finance facility for a portfolio of five ethanol plants in February 2007. It was the first time that a project financed ethanol deal had closed without a guaranteed engineering, procurement and construction (EPC) contract.
The developer closed the financing in a volatile ethanol market where production overcapacity combined with rising corn prices to unsettle debt and equity investors. The challenge was to structure a deal that reassured potential bank participants, without imposing too many burdens on the sponsor.

The sponsor, Pacific Ethanol, has a destination-based business model and its strategy is to develop plants near the booming terminal markets on the West Coast, rather than being close to the corn belt of the Midwest where cheaper feedstock is available. The model is based on the fact it is cheaper to transport corn than ethanol.

Syndication and financial close occurred simultaneously on 28 February, with the balance between the sponsor and lenders finely struck as banks came in on a one-to-one subscription. Five banks came in at lead arranger level: WestLB (sole bookrunner, administrative and collateral agent), Mizuho Corporate Bank (co-syndication agent), CIT (co-syndication agent), Rabobank (co-documentation agent) and Banco Santander.

The financing breaks down into a $200 million commercial bank A tranche, and a $100 million B tranche, and includes a $25 million working capital facility. The A tranche is priced at 375bp over Libor during construction and 325bp thereafter, while the B tranche priced at 435bp. Both loans have a seven-year term. The sponsor raised $138 million in equity in May 2006.

The principal comfort to lenders was that Pacific Ethanol had to deliver two completed plants fully constructed and operating at or above nameplate capacity as a condition to funding any of the three greenfield plants. Therefore, Pacific Ethanol's track record as a constructor could be proven whilst providing operating cash flows to service the debt.

Ethanol deals usually benefit from a full guarantee on their EPC contracts, but Pacific Ethanol wished to proceed as the constructor because it had the necessary expertise among its personnel and because it felt it could reduce costs and deliver completed plants more promptly.

As well as the security of two operating plants, there is a healthy amount of equity at plant-level: for each greenfield project, the sponsor needs to contribute a minimum of 60% of the total project costs before any loan disbursement.

The individual projects will only be levered to 40% once an independent engineer has filed a report, and there is a majority approval among the lenders. The individual project risk is mitigated still further by a budgeted contingency of around 10% of the construction costs. Pacific Ethanol has also entered into a sponsor support agreement to contribute an additional 15% of contingency in case of cost overruns.

Once each of the greenfield plants pass their respective performance tests, the borrowers will receive an additional disbursement of 20%, which will be funded after demonstrating that the plant runs to nameplate capacity.

The debt repayment schedule amortises at 6% per year to give Pacific Ethanol some headroom with the debt service and lower the risk of default. There are 50% cash sweeps in the first two years and 75% in the third year, although if there is an option to sweep up to 100% if capital repayment targets are not met.

On 10 December, Pacific Ethanol announced that it had suspended construction of its Imperial Valley project near Calipatria, California until market conditions improve. The project was delayed by permitting issues and therefore falls outside of the timetable of the project financing. Around $50 million was earmarked for the project, which will now be developed outside these facilities. Despite this setback, Pacific Ethanol is confident of achieving its goal of 220 million gallons per year of ethanol production capacity in 2008 and to increase total production capacity to 420 million gallons per year in 2010.

During 2007 there was a run on corn prices while ethanol prices remained relatively low, causing a liquidity squeeze for ethanol producers. A challenge for WestLB, the bookrunner, was to convince the banking community of the robustness of the deal, particularly European banks unfamiliar with the mix of high corn prices and seasonally low gasoline prices in December and January (ethanol prices track gasoline prices). The squeeze was hardest felt at the end of 2007 and was directly reflected in the metrics of ethanol deals, with project finance debt pricing at around 8-9% over Libor.

However since the passing of the Energy Independence and Security Act in December 2007, there has been a significant increase in ethanol prices, which perhaps signals that ethanol producers have weathered the worst of the storm. The Act extends the Renewable Fuels Standard by requiring 36 billion gallons of renewable fuel be used per year by 2022. Ethanol is trading at around $2.35 per gallon on the West coast and the crush spread stands around $1.4.
Pacific Ethanol's operating ethanol plants are located at Madera, California, and in Boardman, Oregon. Since suspending its Imperial Valley project it has two additional plants under construction in Burley, Idaho, and in Stockton, California.

The durability of the deal in an inhospitable market – brought about by the security of the operating assets, project-level equity and the ongoing monitoring through disbursement – will set down a marker for other owner-construct projects. It is likely to be replicated for smaller producers keen on expanding existing operations.

Pacific Ethanol
Status: Financial close 28 February 2007
Location: California, Oregon and Idaho
Description: First non-recourse owner-construct ethanol plant financing
Sponsor: Pacific Ethanol
Lead arrangers: WestLB; Mizuho; CIT Capital Securities; Rabobank Nederland; Banco Santander
Sponsor legal counsel: Latham & Watkins
Lender legal counsel: Chadbourne & Parke
Market consultant: Muse Stancil
Independent engineer: Luminate
Insurance adviser: Moore-McNeil