I rarely dive into the political arena with you guys, for several reasons (the biggest of which is that I just don't want to ruffle feathers for no real reason). I'm going to somewhat break my rule today though, and tiptoe into a political minefield that has everything to do with a name many of you may have gotten into lately ....Pacific Ethanol Inc. (NASDAQ:PEIX).
This long-struggling ethanol producer's stock made a 180 degree turn near the end of October, reversing a near-100% drubbing from the highs seen in early 2010 to a low of $0.25 hit in mid-September. Something really started to happen after October 26th though, 'cause the stock has soared from $0.34 to today's price of $0.67 in the meantime, and is still going strong.
That 'something' was earnings - they were great. The company earned $0.12 per share versus a loss of $1.10 per share a year earlier. On a sequential basis, that was better than Q2's EPS of $0.03.
Here's the thing about relying in the apparent trend going forward (and this is the part I don't know if all investors quite get)... ethanol's earnings strength is dependent not directly on actual demand, but on the price of gasoline. As gas prices rise, so too do ethanol prices. The company was able to sell it (ethanol) at $2.97 per gallon in Q3 versus only $2.79 in Q2. That last $0.18 was obviously a game-changer though, much more so than the 22% improvement in volume sales from one quarter to the next.
And therein lies the pitfall for excited Pacific Ethanol Inc. shareholders: How much longer are prices at the pump going to stay elevated enough to prop up these strong earnings from one of the market's pure ethanol plays?
Frankly, I'm surprised the company was able to do as well as it did in Q3 relative to Q2, in that gas prices actually fell back in the third quarter of this year. The price for a gallon of gasoline averaged about $3.75 in Q2, but only around $3.60 in Q3. That's still serviceable for ethanol producers, but fuel prices have fallen back again to an average of $3.43 as we approach the midway point of Q4 [a trend crude oil prices have not followed over the past few weeks; they're back on the rise].
Said more plainly, after a hot Q2 we seem to be getting back to the point where ethanol's pricing power isn't quite strong enough to make the business 'worth it'.
And what is that point exactly?
There are some lingering debates on the details, but the general consensus is that crude oil has to be priced above $95 per barrel for ethanol producers to maintain profitability, after factoring in production and distribution costs. It's at $96/barrel right now, and tepidly rising, even though gas prices are stuck around $3.46.
At the same time, corn prices need to stay below the $7.90/bushel area in order for ethanol players to keep on turning a profit; some say $6.85/bushel is the magic number. No problem there either. Corn toyed with $8.00 in the middle of the year, but has since fallen back to the higher $6'00's... more than enough of a cushion to keep ethanol in business (and part of why Pacific Ethanol's Q3 may have been so profitable versus Q2).
There's no real make/break number for gasoline, since it and ethanol are interlocked... usually. It just needs to be cheaper than gas.
[And just for the record, though this is the crux of the relationship, this is the way-simplified explanation - there are a ton of moving parts involved.]
Point being, rising crude prices are good for ethanol stocks. Cheaper corn is good for ethanol stocks. But, stagnant (to falling) gas prices aren't helping ethanol producers, and that last little molehill is about to become a mountain, in my opinion.
The current subsidy for each gallon of ethanol produced is still $0.51, while the import tariff is still $0.54. Now, remember the current price of gasoline? It's $3.43. The current price of ethanol is $2.67...slightly lower than the average $2.79 price Pacific Ethanol was able to sell it at in Q2, when profits were anemic.
See where this is going? Rising ethanol prices, falling gas prices, with the difference being something close to the subsidy itself? Crude prices are modest at best too; none of it exactly sends buyers flocking to the ethanol industry. This full-screen chart says it all.
Now, I don't know how long these trends will last. Maybe through tomorrow, maybe through next year. Either way though, I've been observing this slow price convergence of the two fuel sources for months now. Ethanol is still generally cheaper, but less and less so as time moves on.
Thing is - and here's the real irony - as the ethanol industry is getting to the point where it's stable and has the infrastructure it needs, ethanol prices are also getting to the point where the only thing keeping these stocks attractive relative to fossil fuel is the subsidy. There's still a lot of interplay between corn, crude, gas, and ethanol, but price parity is approaching as stability improves... for the worse, it seems.
This is where it gets political, though bear in mind I'm politically agnostic - I'm just pointing out what I see.
Bluntly, I'm sick of the subsidy debate. My opinion is an industry should be able to stand on its own two feet eventually, and your tax dollars have been keeping ethanol afloat for a little longer than we'd normally like. But hey - that's life.
By the end of next month though, it may not matter.
The Federal subsidy of ethanol production has been on the chopping block for a long time, and this year is no exception. This year though, it looks like the axe is finally going to swing down. Yeah it's an assumption that's been made before and never came to pass. The votes are really getting lopsided now though, and it doesn't look good - Obama's veto power is the only thing standing in the way, and that's a thin-ice proposition. Check out here, here, and here to see what I mean.
Pacific Ethanol says it doesn't care either way, because the metrics of that ethanol industry now support the business as a stand-alone venture. To that I can only say this..... ya' really think so?
That may have been the case last quarter, and even for the last several quarters. The math doesn't make as much sense as PEIX is implying though, at least now that the prices at the pump are low-ish, and ethanol has kinda' priced itself out of the market again with prices at two-year highs. It was a bit of a perfect storm that isn't being repeated now.
Bottom line? I'm not bashing PEIX, but I don't see a lot more upside ahead in Q4. The math above is a big part of the reason, but even without that the company has maxed out in terms of its current capacity. Throw in the backdrop of subsiding ethanol prices oddly paired with falling gas prices, and margins are poised to decrease even though sales volume doesn't.
In the meantime though, I'd be the first to say Pacific Ethanol looks like a great trade. The market's falling in love with it, and from a technical perspective you gotta' love the way it regrouped today and found support at the 100-day moving average line. I'm just not sure how much gas, errrr, ethanol is left in its tank.
That's just one opinion anyway. What do you think? Is PEIX viable without subsidies no matter what gas prices look like, or was this company just lucky due to some unusual circumstances last quarter? You can share your thoughts on the Pacific Ethanol StockHQ page, or you can leave a message about this newsletter by finding the archive here. Sound off.