Pacific Ethanol, Inc.

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Pacific Ethanol, Inc.

5711 North West Avenue
Fresno, California 93711
U.S.A.
Telephone: (559) 435-1771
Fax: (559) 435-1478
Web site: http://www.pacificethanol.net

Public Company
Incorporated: 2003
Employees: 12
Sales: $87.6 million (2005)
Stock Exchanges: NASDAQ
Ticker Symbol: PEIX
NAIC: 325998 All Other Miscellaneous Chemical Product and Preparation Manufacturing; 311225 Fats and Oil Refining Blending

Pacific Ethanol, Inc., markets and distributes ethanol, the first step in the company's goal of becoming the leading ethanol producer and marketer in the western United States. The company is building its first ethanol production plant in Madera County, California, the first of five or more production facilities it intends to build. While construction is underway, Pacific Ethanol earns its living through a subsidiary, Kinergy Marketing, LLC, that operates as a marketer and distributor of ethanol, shipping ethanol made in the Midwest to customers in California, Arizona, Nevada, and Oregon. Pacific Ethanol anticipates opening five ethanol production plants by 2008. By 2010, the company hopes to produce 420 million gallons of ethanol annually.

BACKGROUND OF ETHANOL

Rising gasoline prices, federal and state legislation, and the growth of California's dairy industry all played a part in spurring Pacific Ethanol's formation, but central to the company's birth was the commitment of two individuals, Bill Jones and Neil Koehler. The entrepreneurs, one a Republican and the other a member of the Green Party, held a deep-seated belief in the commercial viability of ethanol. Of the two, Koehler assumed a more active role in the ethanol industry during the two decades leading up to Pacific Ethanol's formation, but Jones took the lead in cobbling together the assets that became Pacific Ethanol, a company poised to confirm the commercial value of ethanol in the early 21st century.

Ethyl alcohol, or ethanol, was enjoying renewed popularity when Jones formed Ethanol Pacific. A clear, colorless fuel extracted from the sugars found in grains and other crops, ethanol was the fuel of choice for lighting devices in the United States in the mid-19th century. Its popularity waned after the federal government levied a liquor tax to raise money for the Civil War, which prompted consumers to turn to less expensive alternatives such as kerosene. Automobile mogul Henry Ford sparked an ethanol revival when he designed the Model T to run on a mixture of gasoline and alcohol, but again federal legislation stifled the use of the fuel. Taxed during the Civil War because it was considered alcohol, ethanol received harsher treatment under Prohibition law, with sales of the fuel banned unless it was mixed with petroleum because of its classification as a liquor. Ethanol was used as a fuel again after the end of Prohibition in 1933, but its use only spiked when oil and other resources were scarce, notably during World War II.

It was ethanol's capability of serving as a total or partial replacement for gasoline that prompted the federal government to encourage its use in the wake of the Arab Oil Embargo of 1973. In response to the petroleum shortage, the U.S. Congress passed the Energy Tax Act of 1978, which exempted the four cents per gallon federal excise tax on gasoline if it was blended with at least 10 percent ethanol. The federal government's support of ethanol production, after a history of restricting the industry's development, sparked interest in the market, including the interest of Jones, who was residing in California at the time. A second-generation farmer and cattle rancher, Jones developed what he called a "destination ethanol" business plan that depended on obtaining corn from the Midwest, extracting ethanol from the corn, and selling a byproduct of the extraction process, wet distillers grain—one of the most nutrient-rich cattle feeds available—to dairy farms in central California. He chose not to execute his business plan, however, convinced that the timing was wrong to launch an ethanol production business in California. "When I looked at this opportunity," Jones reflected in a June 11, 2006, interview with the Fresno Bee, "we didn't have the cows out here to consume the byproduct, we didn't have the market [for ethanol], and we didn't have the distribution to move the product."

Shelving his immediate plans for starting an ethanol company, Jones continued working on his farm in Fresno County, but he hoped to one day revisit the idea of a destination ethanol business. During the two decades spanning his original interest in the industry and the formation of Pacific Ethanol, Jones divided his time between farming and cattle ranching and pursuing a political career. He was elected to the California Assembly in 1982, where he spent a dozen years, including two years as the body's Republican leader, before being elected as California's Secretary of State in 1994. Jones's political career, which also included failed campaigns for the Governor of California and the U.S. Senate, occupied his time until January 2003, when, as quoted in his interview with the Fresno Bee, "it looked … like the timing was very good" to enter the ethanol business. For Neil Koehler, proper timing was never an issue as it related to operating an ethanol business. "All I've done in my professional life is ethanol; it's something I saw out of college, and I've dedicated myself to it ever since," he said in his portion of the Fresno Bee interview. While Jones bided his time, Koehler jumped into the fray, cofounding Parallel Products, California's first ethanol production company, in 1984. Koehler sold Parallel Products in 1997, but he continued his involvement in the ethanol industry, founding an ethanol sales and distribution company, Kinergy Marketing, that eventually became Pacific Ethanol's financial backbone.

In the years leading up to the formation of Pacific Ethanol, the prospects for running an ethanol production business brightened considerably. Its use during gasoline shortages, notably during World War II and the early and mid-1970s, created surges in demand, but times of crises were not enough to sustain consistent business for ethanol producers. During the mid-1980s, for instance, crude oil and gasoline prices fell sharply, forcing 45 percent of the nation's ethanol producers to go out of business despite exceptionally low prices for corn and a federal subsidy of 60 cents per gallon.

As the years passed, however, another attribute of ethanol added to the commercial viability of producing the renewable fuel. Carbon monoxide emissions became an issue, and ethanol, as an additive to gasoline, worked as an oxygenate, increasing the amount of oxygen in the gasoline blend and improving its air-quality characteristics. State and federal authorities turned to oxygenated fuels as a way to combat smog, leading to the first use of ethanol for such purposes in 1988.

Legislation in succeeding years, including the passage of the Clean Air Act in 1992, mandated the use of oxygenated fuels in certain areas, but the market for oxygenates quickly was dominated by another smog-fighting gasoline additive, Methyl Tertiary Butyl Ether, or MTBE, derived from natural gas and petroleum. At the turn of the century, however, MTBE began to lose its grip on the market. In 1999, some states began to ban MTBE's use after it was discovered that the additive polluted groundwater and caused cancer in animals, prompting the Environmental Protection Agency (EPA) to recommend a national ban the following year.

COMPANY PERSPECTIVES

Pacific Ethanol Inc.'s mission is to become the West Coast's leading marketer and producer of renewable fuels. Our product line currently emphasizes clean-burning corn-based ethanol. With over twenty years of experience in biofuels development, we are strategically poised to meet the explosive demand for domestically sourced alternative fuels.

As the outlook for MTBE soured, ethanol, includ-ing a derivative of ethanol, Ethyl Tertiary Butyl Ether (ETBE), stood as the only other commercially viable way to make mandated oxygenated fuel. For Jones, who was waiting for the proper conditions to make a foray into ethanol production, the end of his second term as the Secretary of State of California in January 2003 seemed a perfect time to become an ethanol entrepreneur. MTBE was on the brink of being outlawed and, significantly, the dairy industry in central California, mainly centered in Tulare County, had grown substantially, providing a crucial element in the successful implementation of his destination ethanol business model.

PACIFIC ETHANOL TAKES SHAPE

For help in starting Pacific Ethanol, Jones turned to his son-in-law, Ryan Turner. Raised in Redondo Beach, California, Turner attended Stanford University, played football for the university's team, and, according to his June 11, 2006 interview with the Fresno Bee, "married into Fresno" after courting Jones's daughter Wendy. Once a member of the Jones family, Turner began working on the farm, starting out as manager of the tomato harvest before working his way up to general manager of the operation. When Pacific Ethanol was founded in January 2003, Turner assumed the post of chief operating officer and attended California State University's Fresno campus at night to earn his M.B.A. From the start, Jones and Turner set their sights on producing ethanol rather than merely distributing the fuel, seeking to earn the 15 percent to 25 percent profit margins commonly enjoyed by ethanol producers instead of subsisting solely on the 1.5 percent to 3 percent profit margins averaged by ethanol distributors. By late 2003, the pair had taken the first step towards production, acquiring a former Coast Grain plant in Madera County for $5.1 million. "What we're trying to take advantage of," Turner explained in a March 4, 2005 interview with the Fresno Bee, "is the intersection of the largest fuel market and the largest feed market in the country."

ACQUISITION OF KINERGY: 2005

Jones and Turner faced two major challenges as they went through the permitting process for the Madera plant. Their company needed capital to complete the construction of the Madera plant and the four other plants they hoped to build. Further, the Madera plant was not expected to be completed until late 2006, which left Pacific Ethanol without a source of revenue to sustain itself for at least three years. Jones and Turner chose to start out distributing ethanol, and the way they jumped into the distribution business was by acquiring Koehler's Kinergy Marketing, LLC. Pacific Ethanol completed the acquisition in March 2005, gaining a thriving business and the expertise of Koehler, who became Pacific Ethanol's president and chief executive officer. Kinergy, aided by federal and state clean air regulations requiring oxygenated fuels, recorded robust growth in the years leading up to its merger with Pacific Ethanol. The company generated $15 million in revenue in 2002, a total that leaped to $87.5 million in 2005. Without Kinergy's revenues for 2005, Pacific Ethanol would have recorded a paltry $15,907 in sales for the year.

The purchase of Kinergy coincided with the resolution of the other pressing issue facing the company's leadership. With ethanol production plants requiring roughly $50 million to build, the company needed a substantial infusion of capital to reach its goal of a total of five facilities. Conversion to public ownership offered the most expedient way to obtain capital, and Pacific Ethanol chose a route that quickened the process of going public. In March 2005, the company acquired a publicly traded, healthcare-services firm named Accessity Corp., completing the deal expressly to acquire a public entity. Accessity's lone operating company, Sentaur, was transferred to Accessity's chief executive officer, leaving Jones, Koehler, and Turner with a public shell that made Pacific Ethanol a public company. "We hoped it would be a little cheaper and little quicker," Koehler explained in a November 2005 interview with Entrepreneur, "but in hindsight it was exactly the right move. It made us one of the few pure-play ethanol stocks in the public markets."

KEY DATES

2003:: Pacific Ethanol is founded in January.
2005:: Kinergy Marketing LLC is acquired, giving Pacific Ethanol a source of revenue.
2006:: Pacific Ethanol sells $145 million of stock, securing some of the money the company will need to construct ethanol production plants.

As Pacific Ethanol faced the start of its life as an ethanol producer, the conditions to support its growth were ideal. California officially phased out the use of MTBE in January 2004, becoming one of 19 states to ban its use. Ethanol use exploded as a result, jumping from 100 million gallons in 2002 to 950 million gallons by 2005. Further, federal legislation was working in the company's favor, specifically the passage of the Energy Policy Act of 2005, which required nearly doubling the use of ethanol to 7.5 billion gallons by 2012. On the finance front, Pacific Ethanol's conversion to public ownership provided access to the capital it needed to build its portfolio of ethanol plants. In November 2005, Cascade Investment LLC, the investment vehicle owned by Microsoft Corporation's Bill Gates, invested $84 million in Pacific Ethanol. The infusion of cash was followed in May 2006 with a $145 million stock sale to institutional investors, which accelerated plans for constructing a second plant near Boardman, Oregon. As the company pressed forward with its plans to complete all five plants by 2008, the years ahead promised to see the demand for ethanol increase substantially, with Pacific Ethanol holding sway as one of the country's largest producers.