VeraSun Doomed as Botched Trades Overwhelm Aid, Gates, Khosla

By Joe Carroll and Mario Parker

Nov. 3 (Bloomberg) -- VeraSun Energy Corp. and U.S. ethanol makers backed by Bill Gates and Vinod Khosla are failing after wrong-way bets on corn prices overwhelmed $20 billion in federal aid and government-guaranteed demand for the fuel additive.

VeraSun, the second-largest U.S. ethanol producer, was the latest in a string of distillers stung by imploding hedges when the Brookings, South Dakota-based company filed for Chapter 11 bankruptcy protection on Oct. 31. Biofuel Energy Corp., whose biggest owners are hedge funds run by David Einhorn and Daniel Loeb, and at least six other distillers have shut down or curtailed operations because of volatile corn prices and narrowing ethanol margins.

Ethanol, a form of alcohol used to stretch gasoline supplies, has been a mainstay of every president's plan to cut U.S. reliance on Middle East oil since Jimmy Carter's administration in the 1970s. In the past decade, the federal government paid $20 billion in subsidies to promote use of the additive, and 48 out of 50 states pay additional incentives. Investors from Wall Street to Silicon Valley took a piece of the action after Congress and the White House ordered oil companies three years ago to almost double ethanol use by 2012.

``This does not help improve the perception of the ethanol industry,'' said Pavel Molchanov, an analyst at Raymond James & Associates in Houston. ``There's not going to be anything left for shareholders.''

Corn futures traded in Chicago more than doubled in the past three years as worldwide demand for the crop expanded to make sweeteners and fuel. U.S. ethanol prices dropped 5 percent because output from new mills grew faster than demand, squeezing margins for distillers.

Derivative Contracts

VeraSun said its downfall was the result of derivative contracts entered into earlier this year that left the company on the hook for high-cost corn just as the grain market was poised to crash. As the threat of crop damage from Midwest flooding receded, corn tumbled 48 percent to close at $4.01 a bushel on Oct. 31.

The company abandoned its traditional instrument for managing corn costs -- so-called short positions, or bets prices will decline -- in July after the price of the grain surged $2 a bushel to almost $8 in less than two months because of flooding, public filings showed.

Concerned that crop damage would drive prices even higher, VeraSun's traders locked in prices for corn in July, near the peak in the spot market, and also entered into an arrangement known as an accumulator contract that required the company to double its purchases if the market dropped.

Falling Prices

Prices did just that as floodwaters receded and farmers discovered the crop wasn't as badly damaged as expected, and the worldwide economic slowdown eased demand for grain. VeraSun's hedges required it to pay $6.75 to $7 for each bushel of corn in the third quarter when market prices averaged $5.78, filings showed.

VeraSun spokesman Mike Lockrem didn't return two messages left on his mobile telephone yesterday. Patty Dickerson, director of investor relations, didn't return a message left on her office phone outside regular business hours. Chief Executive Officer Donald Endres couldn't be reached at his South Dakota home.

Earlier in the summer, Microsoft Corp. co-founder Bill Gates sold his stake in Pacific Ethanol Inc. in a series of tranches that culminated in June, public filings showed. Gates had helped legitimize ethanol as a mainstream investment in 2005 when he bought shares in the Sacramento-based company.

Another prominent investor is Khosla, the co-founder of Sun Microsystems Inc., who has bought shares in at least three ethanol producers, including Los Angeles-based Altra Biofuels, which has plants in Indiana and Ohio, and two firms developing technology to distill ethanol from agricultural waste.

Burning Cash

Most analysts failed to anticipate VeraSun's collapse. Among those tracked by Bloomberg, 11 analysts have a ``hold'' rating on its stock, two say ``buy'' and five urge investors to sell.

The company burned through 74 percent its cash during the first half of this year, public filings showed. By late last week, just $6 million of a $126 million revolving credit facility remained available, Moody's Investors Service Inc. said Oct. 30.

VeraSun was facing a ``critical liquidity situation,'' Moody's said just hours before the company announced last week it was seeking protection from creditors in a Wilmington, Delaware, court.

CEO Endres, the company's largest shareholder, sought to raise capital on Sept. 16 with an offering to issue 20 million new shares.

The offering, announced the same day the company disclosed its third-quarter loss could reach $103 million, would have raised $101.6 million, based on the average price of VeraSun shares in the seven days preceding the offering.

Share Sale Canceled

The stock plunged 72 percent in the two days after the loss and share sale were announced and Endres abandoned the offering on Sept. 18.

Other ethanol makers hurt by volatile grain prices, narrowing production margins and the glut of U.S. supply include Gateway Ethanol LLC, Heartland Ethanol LLC, LiquidMaize LLC, Greater Ohio Ethanol, Glacial Lakes Corn Processors and Abengoa SA.

Denver-based Biofuel said in August that it didn't have enough liquidity to cover $46 million in losses on contracts for corn, ethanol and the natural gas used to run its distilleries. The company locked in third- and fourth-quarter corn costs of $7.01 and $6.90 a bushel, respectively. The stock fell 81 percent since the disclosure.

Ethanol Futures

Ethanol futures traded in Chicago fell 26 percent this year, touching a 13-month low of $1.66 a gallon on Oct. 22. The average margin earned from distilling a gallon of ethanol tumbled 68 percent to 41 cents this year from $1.24 in 2006, according to data compiled by Bloomberg.

In addition to the wrong-way bets on corn prices, VeraSun invested in new mills and acquisitions to increase output when a surfeit of U.S. supply was already driving ethanol prices lower.

VeraSun spent $1.5 billion on acquisitions since first selling shares to the public in June 2006, adding eight distilleries to its portfolio. VeraSun also built three new plants with capacity to make 330 million gallons of the fuel annually.

The company halted production last week at a Linden, Indiana, distillery acquired in August 2007 from Dallas-based ASAlliances Biofuels LLC, whose owners included hedge-fund manager D.E. Shaw & Co. The company gave no reason for the Oct. 28 closure, three days before the bankruptcy filing.

VeraSun owns 16 plants in eight states that can produce 1.64 billion gallons of ethanol a year, or about 15 percent of the domestic supply.

To contact the reporters on this story: Joe Carroll in Chicago at jcarroll8@bloomberg.net; Mario Parker in Chicago at mparker22@bloomberg.net.