Valero's Bullish Ethanol Thesis

Valero Energy Corporation (NYSE:VLO) is the nation’s third largest producer of ethanol, producing about 400 million gallons per day in the third quarter, about 10 percent of the U.S. industry. Privately-held POET LLC is the largest and Archer-Daniels-Midland (NYSE:ADM) is in second place.

In its third quarter 2019 earnings report, the Ethanol segment generated a $43 million operating loss, as compared to a $21 million in operating income in the third quarter of 2018. It attributed the decrease from the third quarter of 2018 to lower margins resulting from higher corn prices.

Corn prices spiked due to adverse weather conditions in the corn belt, which delayed planting in the spring and early summer. However, VLO could have hedged its margin by simultaneously buying corn and selling ethanol in advance.

Ethanol prices did rise…

…but not fast enough to keep the margin from literally being crushed.

Operating margins remained below capital costs for the industry.

Valero’s Thesis

On the earnings conference call, Martin Parrish, Senior Vice President of Alternative Fuels, said that October is “looking a lot better than the third quarter did.” The market had been oversupplied with inventory.

But production has recently declined…

…and that has caused stocks to drop about 2.5 million barrels lower than last year.

He cited reasons for being bullish longer term:

Ethanol is going to be in the U.S. gasoline mix for the long run. We expect to see some small incremental demand in the U.S. from higher octane and fuel efficiency standards and some small incremental demand from year round E15 sales. And then we expect, really the big thing we expect is a rebound and the export growth due to favorable blend economics, just the economics to blending ethanol and then these global renewable fuel mandates. So we still feel very constructive in the long-term and think that’s going to be around the corner.”

Supply Destruction

ADM CEO Juan Luciano has a different view.

“We continue to work on the operational and legal separation of our ethanol dry mill assets as a stand-alone business that will facilitate the eventual sale, joint venture or spin of this business.”

ADM reported a $26 million operating loss in the second quarter as sales dropped 20 percent to $757 million. It is pivoting out of the ethanol business and into the nutritional and ingredients sector. Since 2014, ADM has spent more than $5 billion acquiring companies that make different flavorings and ingredients, according to one report.

And Green Plains, Inc.’s (NASDAQ:GPRE) strategic initiative is to convert its ethanol plants to “protein factories,” food for cows and chickens. The rationale is that the protein ingredients market pays much more for the product than does the ethanol market.

Source: Green Plains, Inc.

Conclusions

The ethanol industry may finally be turning around, given the drop in uneconomic oversupply. Because ethanol is a relatively small segment of Valero's business, it has been able to sustain its biofuel business even during challenging market conditions. And operating income for the Renewable Diesel segment was $65 million compared to $5 million operating loss in the third quarter of 2018.

I agree that the fundamentals are improving and that VLO's Ethanol Segment should add to profits in the future, rather than detract. Valero is committed to the biofuels business, and it should prosper, as climate change issues reduce fossil fuel use over time. Are you pleased with your energy sector returns?

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