Hearings and Business Meetings

SD-366 Energy Committee Hearing Room 02:30 PM

Mr. Daniel More

Managing Director and Head of Renewable Energy Investment Banking, Morgan Stanley

June 19, 2006
Testimony to the Committee on
Energy and Natural Resources


Morgan Stanley is a global financial services firm and a market leader in securities, asset management and credit services. Morgan Stanley has a market capitalization of approximately $60 Billion, with more then 600 offices located in 30 countries around the globe.

My name is Daniel More. I am a Managing Director and Head of the Renewable Energy Effort within Investment Banking. I have been an investment banker for 28 years and have focused on the Energy Sector for the last 20 years. I have worked on equity and debt financings, restructurings, privatizations and mergers & acquisitions for clients in the Energy Sector on six continents. I received my undergraduate degree from Colby College and an MBA from The Wharton School of Finance.  I have been invited to testify on how Wall Street views the Renewable Energy sector, specifically focusing on investments in the biofuel sector.

Recent History

As recently as one year ago, discussion of public market equity investments in the
bioenergy sector and ethanol space was seen by most as being somewhat premature. The ethanol investments were primarily sourced from venture capitalists, private equity investors and wealthy individuals. These investors were making relatively small investments in the sector while facing a high level of risk given the uncertainties facing the industry. The investments these private investors made in the Ethanol industry were characterized by little or no liquidity. Because the Ethanol producers were using the investment proceeds to build plants and to start up production there were often no dividends paid. And in addition to the riskiness of this type of early stage investment the Ethanol business remained highly volatile. Volatile margins and fears of oversupply made it difficult for the Ethanol producers to obtain these investments. Not surprisingly the “cost” of this capital was relatively high. These early stage investors needed to be
compensated for the risks they were taking.

Volatility

Volatility in the Ethanol space, as has been widely recognized, has been extremely high. (See Exhibit 1). Over the last 10 years the margins (defined as the difference between the cost of producing the Ethanol and the price for which it can be sold) have ranged from robust to negative. Such volatility in a commodity product will always make financing difficult and relatively expensive. Investors will gain greater comfort for investing in producers of a commodity/product when they perceive that the inherent volatility in a commodity product is outweighed by fundamental need for the product and steady growth in the need for such commodity. In the past, that was not necessarily the case for Ethanol. There have been several drivers which have made Investors (both Debt and Equity) more comfortable with taking the risk on Ethanol and other Biofuels.

Recent Events - Debt Financing

Traditionally Ethanol plants were financed through bank financings, very often with the lead role being played by lending institutions which had a strong background in agriculture based lending. In order to obtain construction financing Ethanol developers had to pledge the plants as collateral. Oftentimes there were restrictions on dividends to owners and interest rates were relatively high due to the scarcity of lenders willing to make what was often perceived to be a risky loan.

Recently, however, the more traditional capital markets for debt financing have been more willing to make investments to the Ethanol industry. These financings are often at a lower all in cost and generally have fewer restrictions and covenants than traditional construction based bank loans. Public Market Financings have been completed for Ethanol plants for several producers. The rating agencies (S&P and Moody’s) still rate all the Ethanol producers as below investment grade. A list of debt financings for Ethanol producers is attached as (Exhibit 2 - At-Issue Bond/Bank Comparables)

Recent Events - Equity Financing

Over the last twelve months, the interest in investing in the Ethanol industry has certainly caught the attention of Wall Street and of the Institutional Investors who drive the investment discussion in the United States and abroad. Investors have suggested to us that a realization that the U.S. dependence on high price foreign oil and the unreliability of such supplies have led such investors to take a fresh look at the Ethanol industry. In the past twelve months several Ethanol companies have “tapped” the public equity markets. Most recently VeraSun Energy raised $483 mm in an IPO that was very well received. Other Companies currently in the process of raising equity financings in the public markets include Aventine Renewable Energy which is currently “on the road” having filed a prospectus to raise $302 mm and Hawkeye Holdings which has filed a prospectus to raise $500 mm. (See Exhibit 3 - Prospectus Cover for VeraSun Energy).

Equity Investor Concerns

Institutional investor acceptance of new capital markets issuances is critical to the long term success and stability of a company’s IPO and share price performance. On the Verasun roadshow many institutional investors were not entirely familiar with the Ethanol industry and the economics of investing in Ethanol. The VeraSun Energy IPO as a success because Management was able to allay the concerns of the Institutional Investors they met and to convince them of the viability of the economic model and to convince them of the potential growth in the industry. (See Exhibit 4 - Case study of VeraSun Energy IPO) The chief concerns that Institutional Investors had with investing in the Ethanol industry
include:

1) Blenders Tax Credit: Continued existence of the $.51 per gallon blenders’ tax credit provided to gasoline refiners. Uncertainty regarding the continued existence of this tax credit introduces a degree of volatility and risk into investments in the Ethanol industry.

An extension of the existing tax credit would serve as an important risk mitigant to
investing in the Ethanol sector, and would likely result in the infusion of additional
capital into the sector, thereby increasing the supply of ethanol in the United States.

2) Foreign Imports: The threat of imports from foreign ethanol producers. The
Ethanol industries in countries such as Brazil have received substantial governmental support over a long time period. The existing tariff on imported ethanol provides U.S. ethanol producers with the support required to ensure that the U.S. Ethanol industry has the ability to mature and compete effectively.
3) Volatility: The volatility of ethanol prices. As I previously discussed, the pricing
environment for ethanol has been characterized by extreme volatility. The continued existence of the blenders’ tax credit is an important mitigant to this volatility.

4) Corn Production: Sufficiency of U.S. corn production at reasonable costs is critical to the long-term success of the Ethanol industry. Investors will continue to invest in the Ethanol sector so long as they are comfortable that the price of corn (which is the largest cost component in the Ethanol process) remains relatively stable.

5) Logistics: Investors are concerned with the logistics of moving the final product to the markets where it is sold. In most cases, the most economical mode of transportation is rail. The ability to have access to rail, to obtain competitive rail rates and lack of congestion to transport Ethanol efficiently is a critical component in Investors’ minds.

6) MTBE Phase-Out: One important use of Ethanol is to replace MTBE in the U.S.
fuel stream. Certain Investors were concerned that the current governmental movement in the U.S. away from MTBE would somehow be reversed. This could have negative effects on the investments in the Ethanol sector.

7) E-85: One area Investors viewed as a positive factor in the current Ethanol space is continued growth in E85 Products. Fuel made up of 85% Ethanol and 15% gasoline currently can be used in approximately six million U.S. autos. Support for the auto manufacturers who produce E-85 “capable” cars and trucks would continue to benefit the industry.

8) RFS minimum levels: Some Investors were concerned that the RFS minimum levels of renewable fuels included in gasoline could be waived by the U.S. EPA. This would cause uncertainty in the industry and would have a negative effect on Ethanol investments.

Summary

Institutional Investors have recently gotten comfortable with the significant risks inherent in investing in the Ethanol and Bio-fuel industry. The framework in which the Ethanol Industry is currently operating seems to be working. Investors crave stability - the biggest risk they face are major changes in the underlying rules under which the current industry is operating.