We prepared the following discussion and analysis to help readers better
understand our financial condition, changes in our financial condition, and
results of operations for the three and nine months ended July 31, 2020 and
2019. This section should be read in conjunction with the condensed
consolidated unaudited financial statements and related notes in PART I - Item 1
of this report and the information contained in the Company's annual report on
Form 10-K for the fiscal year ended October 31, 2019.
Disclosure Regarding Forward-Looking Statements
The SEC encourages companies to disclose forward-looking information so
investors can better understand future prospects and make informed investment
decisions. As such, we have historical information, as well as forward-looking
statements regarding our business, financial condition, results of operations,
performance, and prospects in this report. All statements that are not
historical or current facts are forward-looking statements. In some cases, you
can identify forward-looking statements by terms such as "anticipates,"
"believes," "could," "estimates," "expects," "intends," "may," "plans,"
"potential," "predicts," "projects," "should," "will," "would," and similar
expressions.
Forward-looking statements are subject to a number of known and unknown risks,
uncertainties, and other factors, many of which may be beyond our control, and
may cause actual results, performance, or achievements to differ materially from
those projected in, expressed or implied by forward-looking statements. While
it is impossible to identify all such factors, factors that could cause actual
results to differ materially from those estimated by us are described more
particularly in the "Risk Factors" section of our annual report on Form 10-K for
the year ended October 31, 2019 as supplemented by the risk factors disclosed in
Item 1A of this report on Form 10-Q. These risks and uncertainties include, but
are not limited to, the following:
Fluctuations in the price of ethanol, which is affected by various factors
? including: the overall supply and demand for ethanol and corn; the price of
gasoline, crude oil and corn, government policies, the price and availability
of competing fuels;
? Fluctuations in the price of crude oil and gasoline and the impact of lower oil
and gasoline prices on ethanol prices and demand;
Fluctuations in the availability and price of corn, which is affected by
various factors including: domestic stocks, demand from corn-consuming
? industries, such as the ethanol industry, prices for alternative crops,
increasing input costs, changes in government policies, shifts in global
markets or damaging growing conditions, such as plant disease or adverse
weather, including drought;
Fluctuations in the availability and price of natural gas, which may be
? affected by factors such as weather, drilling economics, overall economic
conditions, and government regulations;
? Negative operating margins which may result from lower ethanol and/or high corn
prices;
? Changes in general economic conditions or the occurrence of certain events
causing an economic impact in the agriculture, oil, or automobile industries;
? Overcapacity and oversupply in the ethanol industry;
Ethanol may trade at a premium to gasoline at times, resulting in a
? disincentive for discretionary blending of ethanol beyond the requirements of
the RFS and consequently negatively impacting ethanol prices and demand;
Changes in federal and/or state laws and environmental regulations including
? elimination, waiver, or reduction of the corn-based ethanol use requirement in
the RFS and legislative acts taken by state governments such as California
related to low-carbon fuels, may have an adverse effect on our business;
? Any impairment of the transportation, storage and blending infrastructure that
prevents ethanol from reaching markets;
? Any effect on prices and demand for our products resulting from actions in
international markets, particularly imposition of tariffs;
? Changes in our business strategy, capital improvements or development plans;
? Effect of our risk mitigation strategies and hedging activities on our
financial performance and cash flows;
? Competition from alternative fuels and alternative fuel additives;
? Changes or advances in plant production capacity or technical difficulties in
operating the plant;
? Our reliance on key management personnel; and
A slowdown in global and regional economic activity, demand for our products
? and the potential for labor shortages and shipping disruptions resulting from
COVID-19.
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We believe our expectations regarding future events are based on reasonable
assumptions; however, these assumptions may not be accurate or account for all
risks and uncertainties. Consequently, forward-looking statements are not
guaranteed. Actual results may vary materially from those expressed or implied
in our forward-looking statements. In addition, we are not obligated and do not
intend to update our forward-looking statements because of new information
unless it is required by applicable securities laws. We caution investors not
to place undue reliance on forward-looking statements, which represent
management's views as of the date of this report. We qualify all of our
forward-looking statements by these cautionary statements.
Industry and Market Data
Much of the information in this report regarding the ethanol industry, including
government regulation relevant to the industry is from information published by
the Renewable Fuels Association ("RFA"), a national trade association for the
United States ("U.S.") ethanol industry, and information about the market for
our products and competition is derived from publicly available information from
governmental agencies or publications and other published independent sources.
Although we believe our third-party sources are reliable, we have not
independently verified the information.
Available Information
Our website address is www.heronlakebioenergy.com. Our annual report on Form
10-K, periodic reports on Form 10-Q, current reports on Form 8-K, and amendments
to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the
Securities Exchange Act of 1934, are available, free of charge, on our website
under the link "SEC Filings," as soon as reasonably practicable after we
electronically file such materials with, or furnish such materials to, the
Securities and Exchange Commission. The contents of our website are not
incorporated by reference in this report on Form 10-Q.
Overview
Heron Lake BioEnergy, LLC is a Minnesota limited liability company that owns and
operates a dry mill corn-based, natural gas fired ethanol plant near Heron Lake,
Minnesota. Our business consists of the production and sale of our ethanol
throughout the continental U.S. and sale of its co-products (wet, modified wet
and dried distillers' grains, corn oil, and corn syrup) locally, and throughout
the continental U.S. Additionally, through a wholly owned subsidiary, HLBE
Pipeline Company, LLC ("HLBE Pipeline Company"), we are the sole owner of
Agrinatural Gas, LLC ("Agrinatural"). Beginning as of December 11, 2019, we
hold a 100% interest in Agrinatural. At October 31, 2019, we held a 73% interest
in Agrinatural. Agrinatural operates a natural gas pipeline that provides
natural gas to Heron Lake BioEnergy, LLC's ethanol production facility and other
customers.
When we use the terms "Heron Lake BioEnergy," "Heron Lake," or "HLBE" or similar
words, unless the context otherwise requires, we are referring to Heron Lake
BioEnergy, LLC and our operations at our ethanol production facility located
near Heron Lake, Minnesota. When we use the terms the "Company," "we," "us,"
"our" or similar words, unless the context otherwise requires, we are referring
to Heron Lake BioEnergy and its wholly owned subsidiary, HLBE Pipeline Company,
LLC, and its wholly owned subsidiary Agrinatural.
Reportable Operating Segments
Operating segments are defined as components of an enterprise for which separate
financial information is available that is evaluated regularly by the chief
operating decision maker in deciding how to allocate resources and in assessing
performance. Based on the nature of the products, services and operations and
the expected financial results, we review our operations within the following
two separate operating segments: (1) ethanol production; and (2) natural gas
pipeline operations. We currently do not have or anticipate we will have any
other lines of business or other significant sources of revenue other than the
sale of ethanol, distillers' grains, corn oil and natural gas transportation.
Refer to Note 12, "Business Segments," of the notes to the condensed
consolidated unaudited financial statements for financial information about our
financial reporting segments.
Ethanol Production
Our primary line of business is the Company's operation of its ethanol plant,
including the production and sale of ethanol and its co-products (distillers'
grains, non-edible corn oil and corn syrup). These operations are aggregated
into one financial reporting segment.
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Our ethanol plant has a nameplate capacity of 50 million gallons per year. We
have received EPA pathway approval and have obtained permits from the Minnesota
Pollution Control Authority to increase our production capacity to approximately
72.3 million gallons of undenatured fuel-grade ethanol on a twelve-month rolling
sum basis. We are currently operating above our stated nameplate capacity on an
annualized basis and intend to continue to do so into the future, dependent on
industry conditions and plant profitability.
In July 2020, the Company experienced major issues with its boiler, which
negatively impacted production. The Company ordered a temporary boiler, which
allowed operations to continue in August 2020 until repair or replacement of the
boiler could be completed. The Company determined that the purchase and
installation of a new boiler would be more economical and efficient than
attempted repairs to the failing boiler. The new boiler is expected to be
installed in October 2020. On September 2, 2020, the Company received notice of
approval of the new boiler from the Minnesota Pollution Control Agency. As a
result, the Company abandoned the failing boiler, is currently operating with
the temporary boiler, and plans to operate with the new boiler upon its
completed installation. The Company will record the cost for the abandonment
during the fourth fiscal quarter once it has determined the asset value, and
what, if any, of the existing equipment can be salvaged. The Company anticipates
a loss of approximately $1.8 million in the fourth fiscal quarter of 2020 due to
the abandonment of the failing boiler. The estimated cost of the new boiler is
approximately $5.2 million.
We have a management services agreement with Granite Falls Energy, LLC, a
Minnesota limited liability company that operates an ethanol plant located in
Granite Falls, Minnesota ("GFE"). GFE owns approximately 50.7% of our
outstanding membership units. Pursuant to the management services agreement, GFE
provides its chief executive officer, chief financial officer, and commodity
risk manager to act in those positions as our part-time officers. The management
services automatically renews for successive one-year terms until either party
gives the other party written notice of termination prior to expiration of the
then current term. The management services agreement may also be terminated by
either party for cause under certain circumstances.
We market and sell our products primarily using third party marketers. The
markets in which our products are sold may be local, regional, national, and
international and depend primarily upon the efforts of third party marketers.
We have contracted with Eco-Energy, LLC to market all of our ethanol, Gavilon
Ingredients, LLC to market our distillers' grains, and RPMG, Inc. to market our
corn oil. We also occasionally independently market and sell excess corn syrup
from the distillation process to local livestock feeders.
Our cost of our goods sold consists primarily of costs relating to the corn and
natural gas supplies necessary to produce ethanol and distillers' grains for
sale at our ethanol plant. We generally do not have long-term, fixed price
contracts for the purchase of corn. Typically, we purchase our corn directly
from grain elevators, farmers, and local dealers within approximately 80 miles
of Heron Lake, Minnesota.
We have a facilities agreement with Northern Border Pipeline Company, which
allows us access to an existing interstate natural gas pipeline located
approximately 16 miles north from our plant. We have entered into a firm natural
gas transportation agreement with Agrinatural, our indirectly wholly owned
subsidiary. We also have an agreement with Constellation New Energy-Gas
Division, LLC to supply the natural gas necessary to operate our plant.
Natural Gas Pipeline
Through our wholly owned subsidiary, HLBE Pipeline Company, we indirectly own
100% of Agrinatural Gas, LLC, a Delaware limited liability company
("Agrinatural"), a natural gas distribution and sales company located in Heron
Lake, Minnesota. On October 18, 2019, HLBE Pipeline Company entered into an
agreement to purchase the 27% non-controlling interest in Agrinatural, which
became effective on December 11, 2019. Prior to December 11, 2019, Rural Energy
Solutions, LLC owned a 27% non-controlling interest in Agrinatural. Agrinatural
owns approximately 190 miles of natural gas pipeline and provides natural gas to
the Company's ethanol plant and other commercial, agricultural, and residential
customers through a connection with the natural gas pipeline facilities of
Northern Border Pipeline Company. Agrinatural's revenues are generated through
natural gas distribution fees and sales. The operations of Agrinatural's
natural gas pipeline are aggregated into a separate financial reporting segment.
Agrinatural has a natural gas local distribution company management agreement
with GFE pursuant to which GFE's chief executive officer and chief financial
officer also hold those same offices with Agrinatural. The agreement
automatically renews for successive one-year terms unless either Agrinatural or
GFE gives the other party written notice
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of termination prior to expiration of the then current term. The agreement may
also be terminated by either party for cause under certain circumstances.
The Company has two intercompany credit facilities with Agrinatural: a July 2014
credit facility, as amended (the "Original Credit Facility") and a March 2015
credit facility, as amended (the "Additional Credit Facility"). Under the
Original Credit Facility, the Company made a five-year term loan in the
principal amount of $3.05 million and pursuant to the Additional Credit
Facility, made a four-year term loan in the principal amount of $3.5 million to
Agrinatural. Subsequent to the closing of the Company's indirect acquisition of
Agrinatural's non-controlling interest in December 2019, the parties agreed to
forgive the debt related to both the Original Credit Facility and the Additional
Credit Facility. Additional details are provided below in the section below
entitled "PART I - Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations - Liquidity and Capital Resources;
Indebtedness."
During the normal course of business, the Company enters into transactions
between its two operating segments as a result of HLBE's firm natural gas
transportation agreement with Agrinatural. These intersegment activities are
recorded by each segment at prices approximating market and treated as if they
are third-party transactions. Consequently, these transactions impact segment
performance. However, the revenues and corresponding costs are eliminated in
consolidation and do not impact the Company's unaudited condensed consolidated
results.
Plan of Operations for the Next Twelve Months
The Company, and the ethanol industry as a whole, experienced significant
adverse conditions throughout most of 2019 and so far in 2020 as a result of
industry-wide record low ethanol prices due to reduced demand and high industry
inventory levels, exacerbated in 2020 by the COVID-19 pandemic. These factors
resulted in prolonged negative operating margins, significantly lower cash flow
from operations and substantial net losses. We expect to have sufficient cash
generated by continuing operations and availability on our credit facility to
fund our operations. However, should unfavorable operating conditions continue
in the ethanol industry that prevent us from profitably operating our plant, we
may need to seek additional funding or further idle ethanol production
altogether.
Over the next twelve months we will continue our focus on operational
improvements at our plant. These operational improvements include replacing the
boilers, exploring methods to improve ethanol yield per bushel and increasing
production output at our plant, continued emphasis on safety and environmental
regulation, reducing our operating costs, and optimizing our margin
opportunities through prudent risk-management policies.
In addition, we expect to continue to conduct routine maintenance and repair
activities at the ethanol plant to maintain current plant infrastructure, as
well as small capital projects, including the construction of additional grain
storage, to improve operating efficiency. We anticipate using cash from our
loans to finance these plant upgrade projects.
Trends and Uncertainties Impacting Our Operations
The principal factors affecting our results of operations and financial
conditions are the market prices for corn, ethanol, distillers' grains, and
natural gas. As a result, our operating results can fluctuate substantially due
to volatility in these commodity markets. Governmental programs designed to
create incentives for the use of corn-based ethanol also have a significant
impact on market prices for ethanol. Other factors that may affect our future
results of operation include those risks discussed below and in "PART II - Item
1A. Risk Factors" of this report, "PART II - Item 1A. Risk Factors" of our
quarterly reports on Form 10-Q for the three months ended January 31, 2020 and
the three months ended April 30, 2020, and "PART I - Item 1A. Risk Factors" of
our annual report on Form 10-K for the fiscal year ended October 31, 2019.
The price and availability of corn is subject to significant fluctuations
depending upon a number of factors that affect commodity prices in general,
including crop conditions, yields, domestic and global stocks, weather, federal
policy, and foreign trade. Natural gas prices are influenced by severe weather
in the summer and winter and hurricanes in the spring, summer, and fall. Other
factors include North American exploration and production, and the amount of
natural gas in underground storage during injection and withdrawal seasons.
Ethanol prices are sensitive to world crude oil supply and demand, domestic
gasoline supply and demand, the price of crude oil, gasoline and corn, the price
of substitute fuels and octane enhancers, refining capacity and utilization,
government regulation and incentives and consumer demand for alternative fuels.
Distillers' grains prices are impacted by livestock numbers on feed, prices for
feed alternatives and supply, which is associated with ethanol plant production.
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Because the market price of ethanol is not always directly related to corn, at
times ethanol prices may lag price movements in corn prices and corn-ethanol
price spread may be tightly compressed or negative. If the corn-ethanol spread
is compressed or negative for sustained period, it is possible that our
operating margins will decline or become negative and our ethanol plant may not
generate adequate cash flow for operations. In such cases, we may reduce or
cease production at our ethanol plant to minimize our variable costs and
optimize cash flow.
Management currently believes that our margins will remain negative or low
during the remainder of the fiscal year 2020. The negative market effects of the
COVID-19 pandemic will likely continue to negatively impact our profitability.
Due to the market risks and uncertainties related to the pandemic and its
ramifications, the Company temporarily idled its operations from on or about
March 30, 2020 through approximately May 31, 2020. June and July also saw lower
than normal ethanol production levels, due primarily to issues with our boilers.
Additionally, continued large corn supplies and ethanol production capacity
increases could have a negative impact on the market price of ethanol which
could adversely impact our profitability. This negative impact could worsen if
domestic ethanol inventories remain high or grow, or if U.S. exports of ethanol
decline. Recent US Energy Information Administration ("EIA") reports indicate
that ethanol stocks remain high since the conclusion of fiscal year 2019.
Further, while ethanol production briefly significantly declined during the
second fiscal quarter of 2020, ethanol production has mostly rebounded during
the third fiscal quarter of 2020. In addition, management believes that
increased waivers of small refiner renewable volume obligations ("RVOs") by the
U.S. Environmental Protection Agency ("EPA"), as well as uncertainty regarding
the Renewable Fuels Standard ("RFS") reset, will contribute to the projected
negative or low margins.
Additionally, while ethanol continues trading at a significant discount to
gasoline, which has improved export demand somewhat, increased waivers of small
refiner RVOs by the EPA has contributed to management's expectation regarding
margins. The impact of the increases in small refiner waivers granted by the EPA
and the reductions in Chinese imports continues to have a negative impact on
prices for renewable identification numbers ("RINs") for corn-based ethanol. As
a result, RINs prices remain lower, removing a blending incentive from the
ethanol marketplace.
Changes in the price for crude oil and unleaded gasoline could have a negative
impact on the demand for gasoline and impact the market price of ethanol, which
could adversely impact our profitability. According to the EIA August 2020 Short
Term Energy Outlook, EIA estimates that U.S. gasoline consumption in the second
quarter of 2020 averaged approximately 7.2 million barrels per day, compared to
approximately 9.5 million barrels per day in the second quarter of 2019.
Additionally, EIA estimates that U.S. gasoline consumption in the third quarter
of 2020 will average approximately 8.8 million barrels per day, compared to
approximately 9.5 million barrels per day in the third quarter of 2019. For all
of 2020, EIA forecasts that U.S. gasoline consumption will average approximately
8.4 million barrels per day, a decrease of approximately 10% compared with 2019.
U.S. gasoline prices averaged $2.18 per gallon in July 2020, an increase of 10
cents per gallon from June 2020, but 56 cents per gallon lower than June 2019.
The EIA forecasts regular gasoline prices to average $1.99 per gallon in the
fourth quarter of 2020, largely due to decreases in travel due to COVID-19 and
reflective of a drop in crude oil prices. The EIA projects that U.S. gasoline
prices will average $2.23 per gallon in 2021, compared with an average of $2.12
per gallon in 2020.
In addition, crude oil prices fell sharply in March and April 2020, remaining
low in June and July 2020 but rebounding slightly, as a result of market
reaction to the COVID-19 pandemic, which caused global demand to decline, and
international price wars. Such marked decreases in crude oil prices have had a
negative impact on the demand for ethanol, which has also been exacerbated by
overall lessened global energy demand as a result of the COVID-19 pandemic.
Continued ethanol production capacity increases could also have a negative
impact on the market price of ethanol, which could be further exacerbated if
domestic ethanol inventories remain high or grow, or if U.S. exports of ethanol
decline. Throughout 2019 and 2020, some U.S. ethanol plants temporarily
suspended production due to negative margins, largely resulting from the
COVID-19 pandemic, and stagnant export projections caused by trade barriers and
decreased global demand in connection with the COVID-19 pandemic.
During our third fiscal quarter of 2020, distillers' grains prices fell, due to
a combination of decreased seasonal demand as well as an increase in supply, as
many ethanol plants resumed production after the shutdowns caused by the
COVID-19 pandemic. In addition to being an animal feed substitute for corn,
distillers' grains are increasingly considered a protein feed substitute for
soybean meal. Management currently believes that the impact of the current
Chinese imposition of antidumping and countervailing duties on distillers'
grains produced in the U.S. has been absorbed into the market. However, recent
trade disputes with China, Mexico and Canada could result in the imposition of
additional tariffs
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on distillers' grains produced in the United States, which could lead to an
oversupply of distillers' grains domestically and negatively impact distillers'
grains prices. Additionally, domestic feeding margins in cattle and hogs in
particular could have a negative impact on total domestic distillers' grains
demand.
Corn oil prices have been slightly negatively impacted during the three months
ended July 31, 2020, which aligns with the recent historic perspective, which
has seen corn oil prices over the past few years be impacted by oversupply of
soybeans and the resulting lower price of soybean oil which competes with corn
oil for biodiesel production, in addition to increased corn oil production. The
impact of lower soybean oil prices and the market's increase in corn oil
production during the last few years will likely continue to impact corn oil
prices.
In December 2019, legislation was signed extending the $1.00 per-gallon
biodiesel blender tax credit retroactively to January 1, 2018 through December
31, 2022. However, corn oil prices may decrease if biodiesel producers reduce
production and/or demand for corn oil is reduced without extension of the
biodiesel blenders tax credit.
Given the inherent volatility in ethanol, distillers' grains, non-food grade
corn oil, grain and natural gas prices, we cannot predict the likelihood that
the spread between ethanol, distillers' grains, non-food grade corn oil, and
grain prices in future periods will be consistent compared to historical
periods.
Impact of COVID-19 on the Company
Operations
The Company, and the ethanol industry as a whole, experienced significant
adverse conditions throughout most of 2019 and so far in 2020 as a result of
industry-wide record low ethanol prices due to reduced demand and high industry
inventory levels. These factors, which have been compounded by the impact of
COVID-19 in 2020, resulted and continue to result in negative operating margins,
significantly lower cash flow from operations and substantial net losses. In
response to these adverse market conditions, the Company idled its ethanol
production from on or about March 30, 2020 through approximately May 31, 2020.
June and July also saw lower than normal ethanol production levels, due
primarily to issues with our boilers. Due to these idles during the third
quarter, ethanol production levels were reduced by approximately 18.6% as
compared to the first half of 2020 production levels. Management believes that
this reduction is warranted due to current negative margins in the ethanol
industry resulting in part from a slowdown in global and regional economic
activity and decreased ethanol demand due to the COVID-19 pandemic. Limiting
ethanol production also results in a corresponding decrease in distillers'
grains and corn oil production. The Company continues to monitor COVID-19
developments in order to determine whether further adjustments to production are
warranted.
Employees
The Company has enacted appropriate safety measures to protect the health and
safety of our employees, customers, partners and suppliers, and we may take
further actions as government authorities require or recommend or as we
determine to be in the best interests of our employees, customers, partners and
suppliers.
Supply and Demand
Although we continue to regularly monitor the financial health of companies in
our supply chain, financial hardship on our suppliers caused by the COVID-19
pandemic could cause a disruption in our ability to obtain raw materials or
components required to produce our products, adversely affecting our operations,
even when operating at reduced production levels. Additionally, restrictions or
disruptions of transportation, such as reduced availability of truck, rail or
air transport, port closures and increased border controls or closures, may
result in higher costs and delays, both with respect to obtaining raw materials
and shipping finished products to customers, which could harm our profitability,
make our products less competitive, or cause our customers to seek alternative
suppliers. Additionally, the COVID-19 pandemic has significantly increased
economic and demand uncertainty. The pandemic has caused a global economic
slowdown, and it is possible that it could cause a global recession. In the
event of a recession, demand for our products would decline further and our
business would be further adversely effected.
PPP Loan
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On April 18, 2020, the Company received $595,693 under the Paycheck Protection
Program legislation passed in response to the economic downturn triggered by
COVID-19. Management expects that the entire loan will be used for payroll,
utilities and interest; therefore, management anticipates that the loan will be
substantially forgiven. To the extent it is not forgiven, the Company would be
required to repay that portion at an interest rate of 1% over a period of two
years, beginning May 2021 with a final installment in May 2022.
Outlook
Although there is uncertainty related to the anticipated impact of the COVID-19
pandemic on our future results, we believe our current cash reserves, cash
generated from our operations, our Paycheck Protection Program loan and the
available cash under our revolving term loan leave us well-positioned to manage
our business through this crisis as it continues to unfold. However, the impacts
of the COVID-19 pandemic are broad-reaching, and the financial impacts
associated with the COVID-19 pandemic include, but are not limited to, reduced
production levels, lower net sales and potential incremental costs associated
with mitigating the effects of the pandemic, including storage and logistics
costs and other expenses. As a result, although we were in compliance with our
financial covenants set forth in our 2020 Credit Facility as of July 31, 2020,
the impact the COVID-19 pandemic could have an adverse impact on our operating
results which could result in our inability to comply with certain of these
financial covenants and require our lenders to waive compliance with, or agree
to amend, any such covenant to avoid a default.
The COVID-19 pandemic is ongoing, and its dynamic nature, including
uncertainties relating to the ultimate geographic spread of the virus, the
severity of the disease, the duration of the pandemic, and actions that would be
taken by governmental authorities to contain the pandemic or to treat its
impact, makes it difficult to forecast any effects on our 2020 fiscal year
results. However, the challenges posed by the COVID-19 pandemic on the global
economy increased significantly as the third fiscal quarter of 2020 progressed,
and as of the date of this filing, management does not anticipate material
improvement in the macroeconomic environment, and, as a result, our results for
the 2020 fiscal year may be significantly affected.
Despite the economic uncertainty resulting from the COVID-19 pandemic, we intend
to continue to focus on strategic initiatives designed to improve on our
operational efficiencies, which is critical in order to drive positive results
in a low-margin environment.
We continue to monitor the rapidly evolving situation and guidance from
international and domestic authorities, including federal, state and local
public health authorities and may take additional actions based on their
recommendations. In these circumstances, there may be developments outside our
control requiring us to adjust our operating plan. As such, given the dynamic
nature of this situation, we cannot reasonably estimate the impacts of the
COVID-19 pandemic on our financial condition, results of operations or cash
flows in the future.
Government Supports and Regulation
The Renewable Fuels Standard
The ethanol industry is dependent on several economic incentives to produce
ethanol, the most significant of which is the federal Renewable Fuels Standard
("RFS"). The RFS has been, and we expect will continue to be, a significant
factor impacting ethanol usage. Any adverse ruling on, or legislation
affecting, the RFS could have an adverse impact on ethanol prices and our
financial performance in the future.
Under the provisions of the RFS, the EPA must publish an annual rule that
establishes the number of gallons of different types of renewable fuels,
including corn-based ethanol, that must be blended with gasoline in the U.S. by
refineries, blenders, distributors, and importers, which affects the domestic
market for ethanol. In December 2019, the EPA released the final 2020 renewable
volume obligations ("RVOs"), which included an overall blending requirement of
20.09 billion gallons for 2020, a slight increase from 2019 mandates.
Conventional corn-based ethanol levels were left at 15.0 billion gallons,
excluding any waivers granted by the EPA to small refiners for "hardship."
U.S. ethanol production capacity exceeded the EPA's 2018 and 2019 RVOs that
could be satisfied by corn-based ethanol. Under the RFS, if mandatory renewable
fuel volumes are reduced by at least 20% for two consecutive years, the EPA is
required to modify, or reset, statutory volumes through 2022. In October 2018,
the Office of Management and Budget announced that the 20% thresholds "have been
met or are expected to be met in the near future." In May 2019, the
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EPA delivered the proposed RFS "reset" rule to the White House Office of
Management and Budget for its review. The EPA is expected to propose rules
modifying the applicable statutory volume targets for cellulosic biofuel,
advanced biofuel, and total renewable fuel for the years 2020-2022. The proposed
rules are also expected to include proposed diesel renewable volume obligations
for 2021 and 2022. If the statutory RVOs are reduced as a result of reset, it
could have an adverse effect on the market price and demand for ethanol which
would negatively impact our financial performance.
There is growing availability of E85 for use in flexible fuel vehicles; however,
it is limited due to lacking infrastructure. In addition, the industry has been
working to introduce E15 to the retail market since the EPA approved its use in
vehicles model year 2001 and newer. Widespread adoption of E15 has been hampered
by regulatory and infrastructure hurdles in many states, as well as consumer
acceptance. Additionally, sales of E15 may have been limited because (i) it is
not approved for use in all vehicles, (ii) the EPA requires a label that
management believes may discourage consumers from using E15, and (iii) retailers
may choose not to sell E15 due to concerns regarding liability. On May 30, 2019,
the EPA issued a final rule which allows E15 to be sold year-round. In June
2019, the American Fuel and Petrochemical Manufacturers association filed a
lawsuit in the U.S. Court of Appeals for the District of Columbia challenging
the final rule. Additionally, in August 2019, the Small Retailers Coalition
filed a lawsuit in the U.S. Court of Appeals for the District of Columbia
seeking review of the final rule. There is no guarantee that the final rule will
be upheld. Legal challenges could create uncertainty for retailers desiring to
implement or expand sales of E15. Additionally, although the year-round E15 rule
is now final, there is no guarantee that retailers will implement the sale of
year-round E15, nor is there a guarantee that the rule will result in an
increase of ethanol sales.
The EPA assigns individual refiners, blenders, and importers the RVOs they are
obligated to use based on their percentage of total fuel sales. Obligated
parties use RINs to show compliance with RVOs. RINs are attached to renewable
fuels by producers and detached when the renewable fuel is blended with
transportation fuel or traded in the open market. The market price of detached
RINs affects the price of ethanol in certain markets and influences the
purchasing decisions by obligated parties. On April 15, 2020, governors of five
states asked the EPA for a refiner waiver from the RFS, contending that refiners
in their respective states face financial burdens due to the COVID-19 economic
downturn. In June 2020, attorneys general of seven states joined in such
request. The EPA has stated that it is "watching the situation closely, and
reviewing the" request.
Under the RFS, small refineries may petition for and be granted temporary
exemptions from the RVOs if they can demonstrate that compliance with the RVOs
would cause disproportionate economic hardship. The EPA has recently granted a
number of these exemptions, whereby such refiners were alleviated of their
responsibility to supply RINS for their obligated volumes based upon the grounds
of economic hardship. On August 2020, 2020, the EPA released data on the number
of waivers filed, which indicated that 28 petitions for waivers for the 2019
compliance year have been received, in addition to three petitions for waivers
for the 2020 compliance year. For the 2018 compliance year, 44 petitions have
been received. To date, with respect to the 2018 compliance year, the EPA has
approved 31 petitions and denied 6 petitions, 5 petitions have been declared
ineligible or withdrawn, and 2 petitions are pending. The 31 approved petitions
have exempted approximately 1.43 billion RINs, which is approximately 13.42
billion gallons of gasoline and diesel, from meeting the RFS blending targets.
The 37 approved petitions for compliance year 2017 exempted approximately 1.82
billion RINs, which is approximately 17.05 billion gallons of gasoline and
diesel, from meeting the RFS blending targets. It is expected that additional
petitions for waivers for the 2019 and 2020 compliance years will be received by
the EPA. It is also expected that the EPA will approve a significant number of
these waiver petitions, thereby exempting a substantial number of gallons of
gasoline and diesel from meeting the RFS blending targets. These exemptions
decrease demand for our products, which negatively impacts ethanol prices and
our profitability.
A proposed rule released by the EPA in October 2019 proposed changes intended to
project the exempted volume of gasoline and diesel due to small refinery
exemptions, regardless of whether such exemptions were actually granted after
the annual rulemaking. However, the final rule released by the EPA in December
2019 provides that EPA will project exempt volumes based on a three-year average
of the relief recommended by the Department of Energy ("DOE") for years
2016-2018, rather than based on actual exemptions granted. For the 2016
compliance year, the EPA said the DOE's recommended relief was approximately 440
million RINs. The EPA, however, actually granted waivers for approximately 790
million RINs. Similarly, the DOE's 2017 compliance year recommendation was 1.02
billion RINs, as compared to the approximately 1.82 billion RINs granted waivers
by the EPA. For the 2018 compliance year, the DOE recommended the EPA approve
waivers for 840 million RINs, as compared to the approximately 1.43 billion RINs
granted waivers by the EPA. The EPA's final rule also announced its general
policy approach with respect to small refinery waivers on a go-forward basis as
consistent with DOE's recommendations, where appropriate. The final rule fell
short of the relief that was
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urged by ethanol producers. As a result, management expects that small refinery
exemptions will continue to have a negative effect on demand for our products,
ethanol prices, and our profitability.
Legal challenges are underway to the RFS, including the EPA's recent reductions
in the RFS volume requirements, the 2018 final rule, and the denial of petitions
to change the RFS point of obligation. If the EPA's decision to reduce the
volume requirements under the RFS is allowed to stand, if the volume
requirements are further reduced, or if the RFS point of obligation were
changed, it could have an adverse effect on the market price and demand for
ethanol which would negatively impact our financial performance.
Beginning in January 2016, various ethanol and agricultural industry groups
petitioned a federal appeals court to hear a legal challenge to of the EPA's
decision to reduce the total renewable fuel volume requirements for 2014-2016
through use of its "inadequate domestic supply" waiver authority. On July 28,
2017, the U.S. Court of Appeals for the D.C. Circuit ruled in favor of the
petitioners, concluding that the EPA erred in its exercise of "inadequate
domestic supply" waiver authority by considering demand-side constraints. As a
result, the Court vacated the EPA's decision to reduce the total renewable fuel
volume requirements for 2016, and remanded to the EPA to address the 2016 total
renewable fuels volume requirements. In December 2019, the EPA announced that it
is deferring action on this issue until an anticipated date in 2020. While
management believes the decision should benefit the ethanol industry overall by
clarifying the EPA's waiver analysis is limited to consideration of supply-side
factors only, no direct impact on the Company is expected from the decision.
On May 1, 2018, the Advanced Biofuels Association submitted a petition with the
U.S. Court of Appeals for the D.C. Circuit challenging EPA's process for
granting exemptions from compliance under the RFS to small refineries. The
Advanced Biofuel Association petition asks the court to review the EPA's
decision to modify criteria to lower the threshold by which the agency
determines whether to grant small refineries an exemption for the RFS for
reasons of disproportionate economic hardship. In May 2019, the U.S. Court of
Appeals for the D.C. Circuit denied a motion by the Advanced Biofuels
Association seeking a preliminary injunction to prevent the EPA from granting
any additional small refinery exemptions under the RFS until its pending lawsuit
with the agency is resolved. In August 2019, the U.S. Court of Appeals for the
D.C. Circuit denied the petition, upholding the EPA's decisions.
Additionally, on May 29, 2018, the National Corn Growers Association, National
Farmers Union, and the Renewable Fuels Association ("RFA") filed a petition with
the U.S. Court of Appeals for the 10th Circuit challenging the EPA's grant of
waivers to three specific refineries. The petitioners are asking the U.S. Court
of Appeals for the 10th Circuit to reject the waivers granted to three
refineries located in Wynnewood, Oklahoma, Cheyenne, Wyoming, and Woods Cross,
Utah as an abuse of EPA authority. These waived gallons are not redistributed to
obligated parties, and in effect, reduce the aggregate RVOs under the RFS. In
January 2020, the court struck down the exemptions as improperly issued by the
EPA. The court interpreted the RFS statute to require that any exemption granted
to a small refinery after 2010 must take the form of an "extension," which would
require a small refinery exemption in prior years to prolong, enlarge or add to.
The court approved a 15-day extension of the deadline to file a petition for
rehearing, which sets the deadline at March 24, 2020. Three small refiners filed
an appeal, but because the Department of Justice did not file an appeal, the
agency is set to implement the decision nationwide.
Related to the recent lawsuits, the Renewable Fuels Association, American
Coalition for Ethanol, Growth Energy, National Biodiesel Board, National Corn
Growers Association, Biotechnology Industry Organization, and National Farmers
Union petitioned the EPA on June 4, 2018 to change its regulations to account
for lost volumes of renewable fuel resulting from the retroactive small refinery
exemptions. This petition to EPA seeks a broader, forward-looking remedy to
account for the collective lost volumes caused by the recent increase in
retroactive small refinery RVO exemptions. In June 2018, the court issued a stay
pending further administrative proceedings. On July 30, 2019, the groups
petitioned the court to lift such stay. It is unclear what regulatory changes,
if any, will emerge from the petition to the EPA. The EPA has not reallocated
volume exemptions in prior years, and continued to approve 31 new requests in
2019. On October 29, 2019, the U.S. House of Representatives Committee on Energy
and Commerce met to examine the effects of the small refinery exemptions on
biofuels and agriculture since 2016. Companies were seeking the EPA to make
available more information on refinery exemptions.
Further, on July 31, 2018, Producers of Renewables United for Integrity Truth
and Transparency filed a petition for review in the U.S. Court of Appeals for
the D.C. Circuit, petitioning for review of final agency action by the EPA in
its decision to allow the generation of RINs by obligated parties under the RFS
that do not represent biofuel production in the year the RIN was generated. In
May 2019, the court issued an order dismissing a portion of the lawsuit
challenging the
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EPA's timing, due to untimely filing. The order also transferred the RINs issues
to the U.S. Court of Appeals for the 10th Circuit.
Also, on August 30, 2018, the RFA and Growth Energy filed a lawsuit in federal
district court, alleging that the EPA and U.S. Department of Energy have
improperly denied agency records requested by RFA, Growth Energy, and others
under the Freedom of Information Act. The requested documents relate to
exemptions from Renewable Fuel Standard compliance obligations granted by EPA.
Additionally, on February 4, 2019, Growth Energy filed a lawsuit in the Court of
Appeals for the District of Columbia against the EPA, challenging the EPA's
"failure" to address small refinery exemptions in its 2019 RVO rulemaking. An
administrative stay has been granted to research the contents of the lawsuit.
Biofuels groups have filed a lawsuit in the U.S. Federal District Court for the
D.C. Circuit, challenging the Final 2019 Rule over the EPA's failure to address
small refinery exemptions in the rulemaking. This is the first RFS rulemaking
since the expanded use of the exemptions came to light, however the EPA has
refused to cap the number of waivers it grants or how it accounts for the
retroactive waivers in its percentage standard calculations. The EPA has a
statutory mandate to ensure the volume requirements are met, which are achieved
by setting the percentage standards for obligated parties. The EPA's current
approach runs counter to this statutory mandate and undermines Congressional
intent. Biofuels groups argue the EPA must therefore adjust its percentage
standard calculations to make up for past retroactive waivers and adjust the
standards to account for any waivers it reasonably expects to grant in the
future.
Although the maintenance of the 15.0 billion gallon threshold for volume
requirements that may be met with corn-based ethanol in the 2020 final rule, in
addition to the year-round E15 rule, signals support from the EPA and the Trump
administration for domestic ethanol production, the Trump administration could
still elect to materially modify, repeal, or otherwise invalidate the RFS. Any
such reform could adversely affect the demand and price for ethanol and the
Company's profitability.
COVID-19 Legislation
In response to the COVID-19 pandemic, Congress passed the Coronavirus Aid,
Relief and Economic Security Act (the "CARES Act") in March 2020 in an attempt
to offset some of the economic damage arising from the COVID-19 pandemic. The
CARES Act created and funded multiple programs that have impacted or could
impact our industry. The USDA was given additional resources for the Commodity
Credit Corporation (CCC), which it is using to provide direct payments to
farmers, including corn farmers from whom we purchase most of our feedstock for
ethanol production. Similar to the trade aid payments made by the USDA over the
past two years, this cash injection for farmers could cause them to delay
marketing decisions and increase the price we have to pay to purchase the corn.
The USDA did not include any CCC funds for ethanol plants as of this filing.
The CARES Act also provided for the Small Business Administration to assist
companies that constitute small business and keep them from laying off workers.
The Paycheck Protection Program (the "PPP") was created and quickly paid out all
of the funds appropriated, including some to farmers and to ethanol plants.
Although we received our PPP Loan under the CARES Act, as discussed above, the
receipt of PPP funds by farmers could, like the CCC funds, incentivize them to
delay marketing corn which could increase the price of corn.
Results of Operations for the Three Months Ended July 31, 2020 and 2019
The following table shows summary information from the results of our operations
and the approximate percentage of revenues, costs of goods sold, operating
expenses and other items to total revenues in our unaudited
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condensed consolidated statements of operations for the three months ended July
31, 2020 and 2019 (amounts in thousands).
© Edgar Online, source Glimpses
HERON LAKE BIOENERGY, LLC 
