Lehman calls bottom on ethanol stocks

We are reiterating our short term trading buy on the ethanol producers.
Over the last two weeks ethanol stocks have fallen 5-18% which we flagged as the potential downside to the price at the time (market has been up 0.8%). We think current lower valuation provides an even more attractive entry point.
Both AVR and VSE are currently trading 10% below replacement cost. If valuations indeed stay here, then we expect new investments to dry up. This may imply that the the industry will move from surplus capacity to being net short by the end of the decade since we do expect the country to move to a 10% ethanol blend over the next 3-5 years. We have started to see that as in the latest update from the Renewable Fuels Association (RFA), the amount of capacity under construction number has dropped by 200 million gallons. Therefore, we don’t think there is much further downside from valuation perspective.
On the upside, we revisit the three potential catalysts we talked about two weeks back:
o Corn price: USDA raising corn crop forecast last week further affirmed our view that there appears to be downside to the corn price especially over October and November when the crop is actually harvested. The industry is short on storage capacity to store the record crop and this should drive down spot prices and perhaps more importantly, next year future strip. Also, this year’s expected large improvement in corn yield to 155.6 bushel/acre, up nearly 4%, should bode well for the ethanol industry in the long run.
o Ethanol continues to trade at a discount to gasoline which gives significant incentive for refiners to start blending more which should narrow the discount. Winter grade gasoline hits at the retail level in October when we should start to see incremental ethanol demand. Even a small increase in blending from 4.6% to 5% would absorb all the ethanol capacity over the next month.
o Legislation: Timing on this is more difficult to pin down and our Washington Research Group has become more pessimistic about the Conference Committee meeting this year. However, we believe that the stocks were anyway not pricing in any upside from legislation two weeks back and now they are around 10% lower (market has been up 0.8%).

Please let us know if you have any questions.
US Integrated Oil Research
Mansi Singhal +1 212 526 8729
Paul Y Cheng, CFA +1 212 526 1884