Farmer-owned ethanol and the role of information technology

Farmer-owned ethanol and the role of information technology

Anthony Crooks

Anthony Crooks and John Dunn, Agricultural Economists USDA Rural Development

Editor’s note: This is the first of a two-part article looking at the impact evolving information technology is having on the nation’s rapidly expanding ethanol industry. In part two, we will take a closer look at the various factors that have converged to spark the industry’s growth, as well as the impact of information technology on production and commercialization of ethanol products.

Advanced information technology (IT) and an increasingly transparent financial sector have become key driving business forces in recent years, having major impacts on operations, strategies, structures, ownership and performance. These forces cut across many industries to force changes which, in turn, have had significant economic and social impacts in rural communities.

Recent writings underscore the depth and extent of the impact of IT on business and industry. Consider just a few:

* Are the impacts of IT adoption any more profound or far reaching than that of other technologies? In his book, Does IT Matter? Information Technology and the Corrosion of Competitive Advantage, Nicholas Carr seems to think not. Carr asserts that IT, as with earlier technologies–railroads, electric power and telephones–is steadily evolving from a profit-boosting, proprietary, resource into a simple utility/commodity and another cost of doing business. Carr contends that the strategic importance of IT has actually eroded as its core functions have become widely available and affordable. Carr’s views were roundly contested.

* In IT Doesn’t Matter Business Processes

Do: A Critical Analysis of Nicholas Carr’s IT article, published in the Hazard Business Review, Howard Smith and Peter Fingar suggest that Carr was only half right. They say Carr’s article is about technology as a business (the IT industry), not the business use of technology for competitive advantage. In other words, Carr has intermixed information technology as a business with the act of using information technology to conduct business. Carr’s article examines the first 50 years of IT and business automation, when the focus was on data function, storage, processing, and transport. In the next 50 years, the core functions of IT are business processes and their functions of storage, processing, and transport.

* In The World is Flat: a Brief History of the 21st Century, Thomas Friedman takes off at a gallop, offering example after example of just how correct Smith and Fingar were. Friedman asserts that is precisely because of IT and business process-processing that the era of mainframe computing–with its command-and-control orientation and companies and/departments organized vertically–has given way to the era of PC-Internet-fiber optics computing and new business practices which are less about command and control, and more about connecting and collaborating horizontally.

* In The Only Sustainable, Edge: Why Business Strategy Depends on Productive Friction and Dynamic Specialization, John Hagel and John Seely Brown assert that businesses thrive when they take full advantage of IT opportunities to negotiate the “productive friction” of their economic environment and begin to coordinate the activities of enterprises, companies and specialties across dimensions of time, space and form to build and accelerate their capabilities. Friedman and Hagel/Brown emphasize the critical importance of digitizing and decomposing work so that it can be moved around in time and space–to be outsourced (or off-shored) for competitive advantage.

IT leveling the playing field for smaller-size business

It is precisely because of evolving IT and business process-processing that mid-sized firms from all over the world compete now on a more level playing field.

Suddenly, mid-sized and even small business have access to the same advantages that were once held exclusively by the larger, vertically integrated firms.

As the fuel ethanol industry ramps out of its developmental stage into a more established role within the U.S. fuels industry, a substantial portion of investments are being made in single plants with annual capacities that range from 50-100 million gallons. Not all ethanol ventures have succeeded. However, a substantial flow of capital investment into ethanol plants continues, unabated.

This emerging industry structure is in sharp contrast with what is typically observed in sectors that process bulk agricultural commodities. Typically, a commodity sector is composed of a few, large multi-plant firms which achieve relative prominence after attaining significant economies of scale, size and scope. These plants then work to capture additional value through their trading and financial operations. These traditional industries are also characterized by a high degree of vertical integration and/or coordination.

The ability of traditional firms to achieve competitive advantage is predicated, in part, on their capacity to develop efficient internal information systems to provide market coordination and links between their operations and global commodity and financial markets, However, the rapid and widespread change in information technologies has arguably eroded the power provided to these global processing concerns.

Objectives

Our hypothesis is that the knowledge-based economy may be fundamentally changing cost structures and the competitive landscape faced by firms in rural America. This became the jumping-off point for this USDA-sponsored study on the future ownership and control of the ethanol industry. The objective of out study was to discover answers to four basic questions:

(1) Does the present ethanol industry represent a stable structure or a transitional step toward an inevitable concentration of ownership into the hands of a few large processing firms?

(2) Have contemporary information technologies fundamentally changed the information flows, scale of operations, access to markets, conditions of vertical and horizontal coordination, sources of finance and the competitive landscape for medium-sized, independent processing firms?

(3) To what degree have cost savings associated with better access to information and financing offset the cost savings traditionally associated with horizontal and vertical integration in processing industries?

(4) What steps do medium-sized ethanol production entities need to take to continue to survive in this new information-based market environment?

The fuel ethanol industry may very well be in transition toward an inevitable concentration of ownership into the hands of a few large processing firms. At present, however, there to be a structural equilibrium seems to be a structural equilibrium among the mid-sized and largest firms. This equilibrium is supported by an industry-wide adoption of contemporary information technologies that serves to enhance medium-sized firms’ access to markets and inputs, while simultaneously diminishing the relative importance of vertical coordination.

The rise of the ethanol plant “franchise”

In the early 1980s, a number of people were exploring the idea of small, portable on-farm stills and 1-million-gallon-per-year plants. They discovered that besides being expensive to build, these plants have to be staffed 24 hours a day and that the job is much more sophisticated than throwing some corn in a vat, and then opening up a spigot the next day to fill up a tractor with ethanol.

Broin, Fagen/ICM and other engineering firms designed “cookie-cutter” ethanol plants with standard designs that can be easily built in most locations. They also provide the financing, conduct feasibility studies and will “hand-hold” producer-investors through the entire process. They can offer an entire package–from feasibility to turnkey and beyond.

This prospect didn’t exist in the early ’90s, when there were many questions about the right way to build a plant. Builders of a 30-million-gallon-per-year plant had to follow a more traditional construction route. This involved hiring a process firm, an engineering firm for the design and a construction management firm, all or some of which may have had no prior experience building an ethanol plant. Uncertainty added significantly to start-up costs and, subsequently, to each step in the process.

However, enough plants have been built to develop a large body of knowledge and experience which has reduced the degree of uncertainty about such projects. Time and expense have been reduced for everything–from the first planning meeting to pouring the first gallon of ethanol.

The standardized designs and business models were pioneered mainly by Broin, Fagen/ICM and a few other companies. These firms began with the recognition that producer groups were developing an investment interest in these plants. They also understood the operating point at which these plants could be profitable–at that time, it was around 40 million gallons per year.

Compared with 10 or 15 years ago, standard design technology has cut in half the costs of construction and the non-energy portion of operations. And while it’s unfortunate that higher natural gas costs have wiped out much of that savings, today’s plants are being built for half the money and operate twice as efficiently as those of the 1990s.

Several factors have contributed significantly to lowering operating costs, including greater corn-to-ethanol conversion rates, which are now commonly 2.85 bushels per gallon, up to three gallons (on a denatured basis) given the right variety of corn. Reduced cost and increased efficiency of enzymes mean that enzymes cost only half of what they did 10 years ago.

Distributed control systems

Prior to the mid-1980s, process automation was comprised of analog loop controls and complex pneumatic controls with individual, large circuit boards dedicated to each control loop. These systems were normally located in control rooms, so the sensors and controller outputs had to be physically connected to the control room.

This resulted in large cable runs full of wires and tubing. Because the systems were bulky and required direct interconnections with the process, there were often several satellite control rooms for each part (or subpart) of the process. These systems required sophisticated maintenance by skilled instrument technicians, and data-logging was done on strip chart recorders. Despite the awkward implementation, these systems replaced hardwired relays and manual controls for critical systems, allowing plants to reduce labor and improve consistency of operation.

But an even more significant contributor to plant efficiency has been the development of information technology systems, the so-called Distributed Control Systems (DCS), and the electronic automation that’s evolved in the plant. DCS were introduced in the late 1980s, enabling centralized process monitoring and control. DCS systems placed integrated circuit board controllers close to the processes that they controlled. Inputs from field instruments and outputs to valves and pumps were converted to 4-20 milliamp signals to minimize signal loss and noise.

They generally run short distances to cabinets in the process area which contained a manageable number of control loops. Each DCS cabinet is connected to a main control computer. Process instruments, output to pumps and valves, and controller settings are driven from a computer console (dashboard) located in a central control room. This design also enables monitoring and control from multiple (and redundant) locations, such as local control rooms, engineering offices or even remote locations.

Expanding system capabilities

During the 1990s, these systems grew in capabilities in step with the geometric growth of information technology applications and abilities. This evolution reduced labor requirements by more than 50 percent during the past 15 years. As computer control, process monitoring and laboratory capabilities further improved, sophisticated data warehousing and analysis systems were adopted to convert the ever-increasing volume of data into useful information. These systems can now monitor process conditions and control settings, as well as laboratory measurements when integrated with a LIMS (Laboratory Information Management System).

Whereas early systems could only retrieve historical information, today’s systems perform complex mathematical manipulations, display graphical results and project future outcomes all in ‘real-time.’ Data manipulation and extraction capabilities enable much narrower process tolerances to further reduce costs and simultaneously increase yields and productivity.

The advantages of DCS systems, data warehousing and analysis include: A reduction in manpower by allowing one operator to monitor and control several processes at once; the ability to see small changes in production variables and correlate them to changes in conditions, raw materials or ingredients; and an increase in overall plant efficiency, because operators can fine-tune process parameters using real-time data and sophisticated analysis.

Early on, plants scheduled several maintenance shutdowns during the year to prevent equipment failures. With the data collection capabilities of the DCS systems, preventive maintenance programs came into a world of their own, reducing downtime for preventive maintenance. These processes and technologies continue to evolve and become even more significant.

Business/bio process metrics & benchmarking

DCS plants all have the same production and business processes and share a data collection and analysis protocol called “benchmarking.” Benchmarking is an array of performance measures that are monitored daily, gathered weekly and summarized monthly to be reported to management and the board. If, for example, a group of 10 plants of common design are all linked together, the business and biological process benchmarks for this group are very well understood.

The manager of any one plant, therefore, can adjust and refine the process to improve his performance and thereby raise the standard of the whole group, in a stair-step fashion. This business process is possible only with today’s information technology, and even now it’s time-intensive to perform. But this would have been virtually impossible 10 years ago.

Firms like Broin and Fagen/ICM were able to expand to their present capacity level because of the information technology employed by the new plants. Broin and Fagen/ICM each direct the operations of some 20 plants.

The talent pool to manage and operate these plants has grown with the process. Both firms employ a cadre of well-seasoned managers who learned during the difficult years how to run a plant efficiently. Both companies provide management services, marketing and procurement contracts to mid-sized plants. This is a far cry from the old days when managers were still putting contracts out and doing everything by hand.

Now–by using information technology and business process technology–a group has the ability to manage about 20 plants as one plant. Fifteen years ago, it would have been nearly impossible to market the product for that many plants and do a good job. Now, an entire array of management services is provided.

There is no way those plants could be managed in this way without improved information technology. The plants themselves are physically too far apart. It would be impossible to oversee so many variables in different parts of the country. The necessary staffing wouldn’t be available because of the expertise required at the control points.

Consolidated marketing partnerships

The rise of marketing firms was instrumental in this trend. Ethanol is not marketed at the processing plant. Buyers (the refiners and blenders of gasoline) don’t want to deal with all these small plants. They demand bulk purchasing–millions of gallons at a time. Buyers want to sign contracts for 50-180 million gallons and want to trade with someone marketing 500 million gallons per year.

The first impact of modern IT on the ethanol industry was as a horizontal coordinator. Many mid-sized firms consolidated their marketing activities out of necessity to bargain with the handful of fuel ethanol buyers who traded in quantities of hundreds of millions of gallons at a time.

Successful consolidated marketing efforts led to innovative applications of these powerful new IT technologies to coordinate other activities horizontally –such as procurement and logistics, risk analysis and eventually plant management–among several plants simultaneously. This horizontal coordination/consolidation role across enterprises, companies and time/space is now performed by five or six firms. Their services are contracted to a substantial majority of the mid-sized, farmer-owned plants.

Over the past few years, the market share of the industry’s major producer (ADM) has dropped from 60 percent to around 30 percent. The balance has been taken by marketing firms–United Bio Energy, Ethanol Products and a few others.

Because fuel ethanol is sold by a dozen marketers and most of it is purchased by a half dozen buyers, information on prices and quantities may be very good within that trading circle, but it is unavailable to outsiders. There is no mandatory reporting of ethanol prices.

Consolidation of process management

It appears that a virtual consolidation of ethanol processing is taking place. Instead of consolidation through ownership, management is becoming more centralized and concentrated. A number of companies–such as Land O’Lakes and Purina, CFC, United Bio Energy and even integrators such as Cargill–are offering management services to facilities other than their own. IT has altered the ethanol industry structure by shifting the ownership and control emphasis from the acquisition of physical production assets to the aggregation of information technology assets. Economic power in the industry no longer arises from ownership of production capital (plants and equipment) but from the control and manipulation of intellectual capital and property rights.

Ethanol marketing/contracting

Ethanol plants typically forward-contract the sale of their fuel twice each year. There is also a spot market, but no real-time pricing exists. Daily prices from Bloomberg, OPIS and Platt are published, but these are reported too late to be of use to traders. Mandatory reporting would be useful to plant managers and boards of directors. Having accurately reported prices would provide a basis of comparison for boards to use in evaluating how good a job their marketing firm is doing, Traders and ethanol giants get price quotes, but no quantity information is available.

Plants want to lock in their corn price and sell their ethanol on a six-month contract in an effort to set a “crush margin.” Longer periods are unavailable because their buyers (refiners and blenders) won’t commit beyond six months. This is a n interesting development, given that energy traders are accustomed to locking prices for up to 10 years in advance.

The marketing of dried distillers grains (DDG)–a major co-product created in ethanol production–is also done primarily by a few firms with a few buyers. The traders on both sides are well informed, but the price reporting is of limited use because the product traditionally is highly variable in quality and there are no specified trading standards. DDG quality varies because of corn quality, the heating/drying process and an inconsistent blending of DOG with solubles. Each of these factors results in a highly variable analysis of DDG. The market discounts the price of DOG for this variability.

Universities provide excellent information on the feeding of DDG to beef cattle, swine and poultry. Some research indicates that DDG has a nutritional value equivalent of 120 to 130 percent of corn, but it sells at a much lower price.

However, while the potential to feed DDG is large, the; feed industry will not incorporate any ingredient rote its rations until there is ready supply in the amount needed to serve their markets. A case in point is ConAgra considering the use of DDG products in its poultry division, It tested numerous products and was reportedly pleased with the nutritional attributes and cost of DDG and wanted to incorporate it into their rations. Eventually, however, reliability was the restricting factor. The whole exercise stopped dead when ConAgra. asked the simple question, “Can you provide us 3 million tons of it?” Such a supply was not then available.

Distributed Centre Systems (DCS)benchmarking enables plants to standardize their distillers grain products to the quality and consistency required by their customers. DCS also gives opportunity for consolidated marketing efforts among partnering plants to have a presence in regional and (soon) national markets because they now have a consistently reliable product, available in sufficient volume and offered at an attractive price relative to corn.

Corn procurement is not as concentrated as corn marketing. Many plants have procurement alliances with their ethanol marketing partners. These are supply agreements and risk-management contracts that work in concert with the marketing contract to provide a reasonable assurance to the plant of a working “grind margin ” However, corn trading/procurement is more fragmented because it is not necessary for a plant to align itself with a major grain-trading company.

One reason for this is that the farmer-owned plants have delivery agreements with their producer members to source a significant portion of the required feedstock locally. A more important reason is that there is a trading history in corn and market transparency because of the Chicago Board of Trade and the futures markets. There’s a local corn “basis,” and a historically well known set of transportation differentials. So, it’s not necessary to align one’s self with a major company to procure feedstock efficiently. However, lenders offer incentives to new plants to contract for risk management services as a way of mitigating their own risk in the project.

Study methods

This study is based on two focus panels of leading ethanol producers and industry experts, held in March 2005, to examine the state and future of the ethanol industry. Industry experts on the panels included representatives from: the commodities exchanges (NYMEX, CBOT), financial firms, producer associations and legal firms that serve the industry, information technology, plant management and an agricultural biotechnology firm. Follow-up interviews among 12 plant managers were also conducted to clarify the information obtained in the focus panels.

COPYRIGHT 2005 U.S. Department of Agriculture, Rural Business – Cooperative Service

COPYRIGHT 2005 Gale Group