The U.S. ethanol market likely won't find equilibrium between supply and demand until 2011-12 at the earliest, some industry experts say.

Although there are several risks to this scenario, namely a change in policy that disadvantages the ethanol industry and prolongs the recovery, several experts generally agree that it would take a minimum of 24 months before excess production capacity and imports would match increasing demand mandated by the Renewable Fuels Standard.

"We have a floor for capacity, and that is the RFS," said Jerome P. Peters, managing director with TD Bank Project Finance. Peters spoke on a panel of industry experts in New York City on March 2nd at a Chadbourne and Parke LLP-hosted event.

Todd Alexander, a partner with the law office of Chadbourne and Parke, moderated the discussion, entitled "Biofuel: Survival Strategies for a Challenging Market," in the firm's offices at Rockefeller Plaza. The discussion focused on ethanol production plant valuations and the near-term future of the industry.

A key dilemma for the ethanol industry is that market prices are following production costs instead of the gasoline market they sell to, which has constrained demand and restricted margins, panelists said. Ethanol's price correlation to costs instead of as a substitute for gasoline is expected to limit margin recovery and force rationalization in the market.

"This creates a commodity dynamic where less-efficient producers are likely to exit until production falls in line with demand set by the RFS mandate and discretionary blending," said Mark Habib, an associate with Standard and Poor's.

In fact, a consensus among the speakers was for "significant consolidation" in the industry over the next two years.

To expound on this point, leveraged ethanol producers have debt service ranging from $1.15 to $1.75 gallon unadjusted for capital leases, according to Habib. This compares with a $1.50 to $1.65 gallon range so far in 2009 for nearby-delivery CME ethanol futures and is on top of operating fixed costs such as feedstock.

"Plant efficiency is critical," said Habib, noting that the operating margins for ethanol plants are wide and varied.

Alexander estimated that 21 percent of ethanol production capacity in the U.S. is shut-in due to poor margins and insolvency.

Tony Lent, managing director with US Renewables Group, estimated a $0.07 gallon production margin for the ethanol industry, with individual plant operators that are burdened with debt stuck with negative returns.

Ethanol's low and volatile margin environment over the past couple of years has chased away private equity, itself in the throes of a deep and prolonged recession exacerbated by a dysfunctional credit market, and that has cut into plant valuations.

"Margin volatility over the past couple of years has really spooked private equity," said Ned Kleinschmidt, executive director with the Capstone Advisory Group, LLC.

This situation has complicated the ability in assigning value to ethanol production plants, which is why the bankruptcy-driven auction later this month of VeraSun's facilities is garnering such a great deal of industry interest.

"Everyone's watching the VeraSun process," said Kleinschmidt, saying what the plants sell for in the auction will set the price for plants going forward.

So far, Valero Energy is the only bidder to have emerged for the auction, which starts March 16, with the oil refiner putting in a stalking-horse bid of $280 million for six of VeraSun's ethanol production plants. That equates to a roughly $0.50 gallon valuation for the ethanol plants, which Lent thinks might be too high.

Lent estimated that ethanol plants are valued somewhere between $0.30 and $0.60 gallon, which will certainly discourage new plant construction. To this point, no new conventional ethanol plants are expected to be built for the next three years at least. For that matter, ethanol plants under construction that are not far along in the process and still need financing could be rejected by lenders and might never reach completion.

There are expectations that more bidders will appear during the VeraSun auction later this month, but it won't be private equity. Instead, the list of likely bidders includes major oil companies, hedge funds and major trader groups.

The logic here is that these groups have the cash for acquisitions and the know-how to work in a low-margin environment, while oil companies are also mandated to use a progressively higher amount of ethanol by way of the RFS. Experienced low-margin operators like oil companies could sit on plants, keeping them idle until the market improves over time.

Lenders could also emerge in the auction process, showing no cash, but bidding for what they're owed to take the assets. However, there is skepticism that banks would want to own an ethanol plant. Of course, they could mothball operations until the environment improves, but there are costs associated with shutting down a plant.

The thinking, too, is that the valuations for these plants will move out of the current depressed levels they are now in over the next couple of years to a $2.25 to $2.75 gallon range. That could be a rosy forecast, however.

There remains a great deal of risk, namely political. In addressing a question from Alexander on the possible removal of the $0.54 gallon tariff on non-Caribbean-based ethanol, Paul Ho, managing director of Hudson Clean Energy Partners, said, "You always have to look at the Brazilian equation."

The fear for the U.S. ethanol industry is a flood of cheap imports from the South American producer that could delay the recovery of the domestic market.

Ho also cited as a significant risk to the industry if the RFS "is not there or reduced." The loss of this mandated demand, which increases from 11.1 billion gallons this year to 36 billion gallons by 2022, he said, would have a punishing effect on the industry.

In 2008, Texas Gov. Rick Perry petitioned the Environmental Protection Agency to have the RFS halved for the second half of 2008 and first half of 2009. The waiver request was denied, but cast a negative pale over the industry during the better than 90-day review period last year. More challenges to the RFS are possible.

On the upside, a crude oil and gasoline price resurgence would drive ethanol plant margins higher, potentially lifting the industry into profitability. However, no one on the panel was willing to wager on that likelihood in the near term.

For now, "the name of the game is to make it through 2009 and see where we are," said Ralph Cho, director with WestLB.