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EX-32.1 - EXHIBIT 32.1 - Pacific Ethanol, Inc.s113524_ex32-1.htm
EX-31.2 - EXHIBIT 31.2 - Pacific Ethanol, Inc.s113524_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - Pacific Ethanol, Inc.s113524_ex31-1.htm

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION 

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One) 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2018

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ______ to _______

 

Commission File Number: 000-21467

 

 

(graphic) 

(Exact name of registrant as specified in its charter)

 

Delaware
(State or other jurisdiction of incorporation or organization)
41-2170618
(I.R.S. Employer Identification No.)
   

400 Capitol Mall, Suite 2060, Sacramento, California 

(Address of principal executive offices)

95814 

(zip code) 

 

(916) 403-2123
(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ☒  No ☐

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes ☒  No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

☐  Large accelerated filer ☒  Accelerated filer
☐  Non-accelerated filer ☒  Smaller reporting company
☐  Emerging growth company  

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ☐ No ☒

 

As of November 1, 2018, there were 45,716,235 shares of Pacific Ethanol, Inc. common stock, $0.001 par value per share, and 896 shares of Pacific Ethanol, Inc. non-voting common stock, $0.001 par value per share, outstanding.

 

 

 

 

 

 

PART I
FINANCIAL INFORMATION

 

    Page
     
ITEM 1. FINANCIAL STATEMENTS  
     
  Consolidated Balance Sheets as of September 30, 2018 (unaudited) and December 31, 2017 1
     
  Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2018 and 2017 (unaudited) 3
     
  Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2018 and 2017 (unaudited) 4
     
  Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2018 and 2017 (unaudited) 5
     
  Notes to Consolidated Financial Statements (unaudited) 7
     
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 19
     
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 32
     
ITEM 4. CONTROLS AND PROCEDURES 33
     
PART II
OTHER INFORMATION
     
ITEM 1. LEGAL PROCEEDINGS 33
     
ITEM 1A. RISK FACTORS 34
     
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 43
     
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 44
     
ITEM 4. MINE SAFETY DISCLOSURES 44
     
ITEM 5. OTHER INFORMATION 44
     
ITEM 6. EXHIBITS 45
     
SIGNATURES 46

 

 

 

 

PART I - FINANCIAL INFORMATION

 

ITEM 1.FINANCIAL STATEMENTS.

 

PACIFIC ETHANOL, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)

 

   September 30,   December 31, 
ASSETS  2018   2017 
    (unaudited)    * 
Current Assets:          
Cash and cash equivalents  $56,093   $49,489 
Accounts receivable, net (net of allowance for doubtful accounts of $11 and $19, respectively)   67,644    80,344 
Inventories   54,766    61,550 
Prepaid inventory   1,442    3,281 
Derivative instruments   1,954    998 
Other current assets   10,367    7,584 
Total current assets   192,266    203,246 
           
Property and equipment, net   488,591    508,352 
           
Other Assets:          
Intangible assets   2,678    2,678 
Other assets   5,012    6,020 
Total other assets   7,690    8,698 
Total Assets  $688,547   $720,296 

 

 

*       Amounts derived from the audited consolidated financial statements for the year ended December 31, 2017.

 

See accompanying notes to consolidated financial statements. 

 

-1

 

 

PACIFIC ETHANOL, INC.
CONSOLIDATED BALANCE SHEETS (CONTINUED)
(in thousands, except par value)

 

   September 30,   December 31, 
LIABILITIES AND STOCKHOLDERS’ EQUITY  2018   2017 
    (unaudited)    * 
Current Liabilities:          
Accounts payable – trade  $44,774   $39,738 
Accrued liabilities   20,885    21,673 
Current portion – capital leases   45    592 
Current portion – long-term debt   20,000    20,000 
Derivative instruments   6,385    2,307 
Other current liabilities   6,931    6,396 
Total current liabilities   99,020    90,706 
           
Long-term debt, net of current portion   214,419    221,091 
Capital leases, net of current portion   89    123 
Other liabilities   23,497    24,676 
Total Liabilities   337,025    336,596 
Commitments and Contingencies (Note 6)          
           
Stockholders’ Equity:          
Pacific Ethanol, Inc. Stockholders’ Equity:          
Preferred stock, $0.001 par value; 10,000 shares authorized; Series A: 1,684 shares authorized; no shares issued and outstanding as of September 30, 2018 and December 31, 2017; Series B: 1,581 shares authorized; 927 shares issued and outstanding as of September 30, 2018 and December 31, 2017; liquidation preference of $18,075 as of September 30, 2018    1    1 
Common stock, $0.001 par value; 300,000 shares authorized; 44,946 and 43,985 shares issued and outstanding as of September 30, 2018 and December 31, 2017, respectively   45    44 
Non-voting common stock, $0.001 par value; 3,553 shares authorized; 1 share issued and outstanding as of September 30, 2018 and December 31, 2017, respectively        
Additional paid-in capital   929,262    927,090 
Accumulated other comprehensive loss   (2,234)   (2,234)
Accumulated deficit   (597,671)   (568,462)
Total Pacific Ethanol, Inc. Stockholders’ Equity   329,403    356,439 
Noncontrolling interests   22,119    27,261 
Total Stockholders’ Equity   351,522    383,700 
Total Liabilities and Stockholders’ Equity  $688,547   $720,296 

 

 

*     Amounts derived from the audited consolidated financial statements for the year ended December 31, 2017.

 

See accompanying notes to consolidated financial statements. 

 

-2

 

 

PACIFIC ETHANOL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS 

(unaudited, in thousands, except per share data)

 

   Three Months Ended 
September 30,
   Nine Months Ended 
September 30,
 
   2018   2017   2018   2017 
                 
Net sales  $370,407   $445,442   $1,180,956   $1,236,984 
Cost of goods sold   366,639    433,377    1,175,099    1,229,039 
Gross profit   3,768    12,065    5,857    7,945 
Selling, general and administrative expenses   8,970    8,720    27,183    22,932 
Income (loss) from operations   (5,202)   3,345    (21,326)   (14,987)
Fair value adjustments               473 
Interest expense   (4,193)   (3,826)   (12,875)   (9,157)
Other income (expense), net   91    (60)   233    (293)
Loss before benefit for income taxes   (9,304)   (541)   (33,968)   (23,964)
Benefit for income taxes           563     
Consolidated net loss   (9,304)   (541)   (33,405)   (23,964)
Net loss attributed to noncontrolling interests   1,790    339    5,142    2,285 
Net loss attributed to Pacific Ethanol, Inc.  $(7,514)  $(202)  $(28,263)  $(21,679)
Preferred stock dividends  $(319)  $(319)  $(946)  $(946)
Loss available to common stockholders  $(7,833)  $(521)  $(29,209)  $(22,625)
Net loss per share, basic and diluted  $(0.18)  $(0.01)  $(0.68)  $(0.53)
Weighted-average shares outstanding, basic and diluted   43,299    42,475    43,171    42,358 

 

See accompanying notes to consolidated financial statements. 

 

-3

 

 

PACIFIC ETHANOL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)

 

   Nine Months Ended  
September 30,
 
   2018   2017 
Operating Activities:          
Consolidated net loss  $(33,405)  $(23,964)
Adjustments to reconcile consolidated net loss to net cash provided by operating activities:          
Depreciation   30,635    28,486 
Deferred income taxes   (563)    
Fair value adjustments       (473)
Amortization of debt discount   539    454 
Amortization of deferred financing fees   754    339 
Non-cash compensation   2,579    2,985 
Loss on derivative instruments   4,362    836 
Bad debt expense   44    4 
Changes in operating assets and liabilities:          
Accounts receivable   12,656    25,625 
Inventories   6,784    (1,891)
Prepaid expenses and other assets   (2,454)   2,197 
Prepaid inventory   1,839    4,397 
Accounts payable and accrued expenses   2,307    (3,995)
Net cash provided by operating activities   26,077    35,000 
Investing Activities:          
Additions to property and equipment   (10,874)   (12,348)
Purchase of ICP, net of cash acquired       (28,921)
Net cash used in investing activities   (10,874)   (41,269)
Financing Activities:          
Net proceeds from (payments on) Kinergy’s line of credit   9,880    (5,889)
Proceeds from ICP credit facilities       42,000 
Proceeds from assessment financing   728    1,144 
Proceeds from notes       13,530 
Payments for debt issuance costs       (924)
Principal payments on borrowings   (17,500)   (54,927)
Payments on capital leases   (761)   (588)
Proceeds from exercise of warrants and options       1,202 
Preferred stock dividends paid   (946)   (946)
Net cash used in financing activities   (8,599)   (5,398)
Net increase (decrease) in cash and cash equivalents   6,604    (11,667)
Cash and cash equivalents at beginning of period   49,489    68,590 
Cash and cash equivalents at end of period  $56,093   $56,923 
           
Supplemental Cash Flow Information:          
Interest paid  $11,299   $8,291 
Income tax refunds received  $743   $5,601 
Noncash financing and investing activities:          
Issuance of notes payable for acquisition of ICP  $   $46,927 
Reclass of warrant liability to equity upon warrant exercises  $   $178 

 

See accompanying notes to consolidated financial statements. 

 

-4

 

 

PACIFIC ETHANOL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(unaudited, in thousands) 

 

   Preferred Stock   Common Stock                    
   Shares   Amount   Shares   Amount   Additional Paid-In Capital   Accumulated Deficit   Accum. Other Comprehensive Income
(Loss)
   Non-Controlling Interests   Total 
Balances, January 1, 2018   927   $1    43,986   $44   $927,090   $(568,462)  $(2,234)  $27,261   $383,700 
Stock-based compensation expense – restricted stock issued to employees and directors, net of cancellations and tax           (31)       735                735 
Preferred stock dividends                       (312)           (312)
Net loss                       (7,841)       (1,656)   (9,497)
Balances, March 31, 2018   927   $1    43,955   $44   $927,825   $(576,615)  $(2,234)  $25,605   $374,626 
Stock-based compensation expense – restricted stock and options to employees and directors, net of cancellations and tax           1,006    1    553                554 
Preferred stock dividends                       (315)           (315)
Net loss                       (12,908)       (1,696)   (14,604)
Balances, June 30, 2018   927   $1    44,961   $45   $928,378   $(589,838)  $(2,234)  $23,909   $360,261 
Stock-based compensation expense – restricted stock and options to employees and directors, net of cancellations and tax           (14)       884                884 
Preferred stock dividends                       (319)           (319)
Net loss                       (7,514)       (1,790)   (9,304)
Balances, September 30, 2018   927   $1    44,947   $45   $929,262   $(597,671)  $(2,234)  $22,119   $351,522 

 

   Preferred Stock   Common Stock                          
   Shares   Amount   Shares   Amount   Additional Paid-In Capital   Accumulated Deficit   Accum. Other Comprehensive
Income
(Loss)
   Non-Controlling Interests   Total 
Balances, January 1, 2017   927   $1    43,312   $44   $922,698   $(532,233)  $(2,620)  $30,371   $418,261 
Stock-based compensation expense – restricted stock issued to employees and directors, net of cancellations and tax           505        1,220                1,220 
Option exercise           10        37                37 
Preferred stock dividends                       (312)           (312)
Net loss                       (12,636)       (849)   (13,485)
Balances, March 31, 2017   927   $1    43,827   $44   $923,955   $(545,181)  $(2,620)  $29,522   $405,721 
Stock-based compensation expense – restricted stock and options to employees and directors, net of cancellations and tax           (37)       127                127 
Warrant exercises           120        829                829 
Preferred stock dividends                       (315)           (315)
Net loss                       (8,841)       (1,097)   (9,938)
    927   $1    43,910   $44   $924,911   $(554,337)  $(2,620)  $28,425   $396,424 

 

-5

 

  

   Preferred Stock   Common Stock                          
   Shares   Amount   Shares   Amount   Additional Paid-In Capital   Accumulated Deficit   Accum. Other Comprehensive
Income
(Loss)
   Non-Controlling Interests   Total 
Balances, June 30, 2017                                             
Stock-based compensation expense – restricted stock and options to employees and directors, net of cancellations and tax           (9)       825                825 
Warrant exercises           71        512                512 
Preferred stock dividends                       (319)           (319)
Net loss                       (202)       (339)   (541)
Balances, September 30, 2017   927   $1    43,972   $44   $926,248   $(554,858)  $(2,620)  $28,086   $396,901 

 

-6

 

 

PACIFIC ETHANOL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

 

1.ORGANIZATION AND BASIS OF PRESENTATION.

 

Organization and Business – The consolidated financial statements include, for all periods presented, the accounts of Pacific Ethanol, Inc., a Delaware corporation (“Pacific Ethanol”), and its direct and indirect subsidiaries (collectively, the “Company”), including its subsidiaries, Kinergy Marketing LLC, an Oregon limited liability company (“Kinergy”), Pacific Ag. Products, LLC, a California limited liability company (“PAP”), PE Op Co., a Delaware corporation (“PE Op Co.”) and all nine of the Company’s ethanol production facilities.

 

The Company’s acquisition of Illinois Corn Processing, LLC (“ICP”) was consummated on July 3, 2017, and as a result, the Company’s accompanying consolidated financial statements include the results of ICP since that date.

 

The Company is a leading producer and marketer of low-carbon renewable fuels in the United States. The Company has a combined production capacity of 605 million gallons per year, markets, on an annualized basis, nearly 1.0 billion gallons of ethanol and specialty alcohols, and produces, on an annualized basis, over 3.0 million tons of co-products on a dry matter basis, such as wet and dry distillers grains, wet and dry corn gluten feed, condensed distillers solubles, corn gluten meal, corn germ, dried yeast and CO2.

 

The Company owns and operates nine production facilities, four in the Western states of California, Oregon and Idaho, and five in the Midwestern states of Illinois and Nebraska.

 

The Company’s four ethanol plants in the Western United States (together with their respective holding companies, the “Pacific Ethanol West Plants”) are located in close proximity to both feed and ethanol customers and thus enjoy unique advantages in efficiency, logistics and product pricing.

 

The Company’s five ethanol plants in the Midwest (together with their respective holding companies, the “Pacific Ethanol Central Plants”) are located in the heart of the Corn Belt, benefit from low-cost and abundant feedstock production and allow for access to many additional domestic markets. In addition, the Company’s ability to load unit trains from these facilities in the Midwest allows for greater access to international markets.

 

As of September 30, 2018, all nine facilities were operating. As market conditions change, the Company may increase, decrease or idle production at one or more operational facilities or resume operations at any idled facility.

 

Basis of PresentationInterim Financial Statements – The accompanying unaudited consolidated financial statements and related notes have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Results for interim periods should not be considered indicative of results for a full year. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. The accounting policies used in preparing these consolidated financial statements are the same as those described in Note 1 to the consolidated financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, with the exception of revenue recognition, as discussed further below. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair statement of the results for interim periods have been included. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

-7

 

 

Accounts Receivable and Allowance for Doubtful Accounts – Trade accounts receivable are presented at face value, net of the allowance for doubtful accounts. The Company sells ethanol to gasoline refining and distribution companies, sells distillers grains and other feed co-products to dairy operators and animal feedlots and sells corn oil to poultry and biodiesel customers generally without requiring collateral.

 

The Company maintains an allowance for doubtful accounts for balances that appear to have specific collection issues. The collection process is based on the age of the invoice and requires attempted contacts with the customer at specified intervals. If, after a specified number of days, the Company has been unsuccessful in its collection efforts, a bad debt allowance is recorded for the balance in question. Delinquent accounts receivable are charged against the allowance for doubtful accounts once uncollectibility has been determined. The factors considered in reaching this determination are the apparent financial condition of the customer and the Company’s success in contacting and negotiating with the customer. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of ability to make payments, additional allowances may be required.

 

Of the accounts receivable balance, approximately $52,693,000 and $64,501,000 at September 30, 2018 and December 31, 2017, respectively, were used as collateral under Kinergy’s operating line of credit. The allowance for doubtful accounts was $11,000 and $19,000 as of September 30, 2018 and December 31, 2017, respectively. The Company recorded a bad debt recovery of $1,000 and bad debt expense of $2,000 for the three months ended September 30, 2018 and 2017, respectively. The Company recorded a bad debt expense of $44,000 and $4,000 for the nine months ended September 30, 2018 and 2017, respectively. The Company does not have any off-balance sheet credit exposure related to its customers.

 

Benefit for Income Taxes – The Company recognized a tax benefit of $563,000 for the nine months ended September 30, 2018 due to the Company’s reduction of its deferred tax asset valuation allowance due to the taxable losses incurred during the period. Under the Tax Cuts and Jobs Act enacted on December 22, 2017, losses incurred after 2017 can be carried forward indefinitely. The Company does not expect additional tax benefits to be recognized during 2018 due to this provision. The Company recognized no tax benefit for the three months ended September 30, 2018 and the three and nine months ended September 30, 2017 due to the uncertainty of using its tax losses to offset future taxable income. To the extent the Company believes it can utilize its tax losses, the Company will adjust its benefit for income taxes accordingly in future periods.

 

Comprehensive Loss – The Company’s accumulated other comprehensive loss relates to the Company’s pension plans. For the three and nine months ended September 30, 2018 and 2017, the Company’s consolidated loss and comprehensive loss were substantially the same amount.

 

Financial Instruments – The carrying values of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities are reasonable estimates of their fair values because of the short maturity of these items. The Company believes the carrying value of its long-term debt approximates fair value because the interest rates on these instruments are variable, and are considered Level 2 fair value measurements.

 

-8

 

 

Recent Accounting Pronouncements – In February 2016, the Financial Accounting Standards Board (“FASB”) issued new guidance on accounting for leases. Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted cash flow basis; and (2) a “right of use” asset, which is an asset that represents the lessee’s right to use the specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged, with some minor exceptions. Lessees will no longer be provided with a source of off-balance sheet financing for other than short-term leases. The standard is effective for public companies for annual reporting periods beginning after December 15, 2018, including interim periods within those fiscal years. The Company expects that upon adoption of this accounting standard, right of use assets and lease obligations will be recognized in its consolidated balance sheets in amounts that will be material.

 

In May 2014, the FASB issued new guidance on the recognition of revenue (“ASC 606”). ASC 606 states that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. In March and April 2016, the FASB issued further revenue recognition guidance amending principal vs. agent considerations regarding whether an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services.

 

The provisions of ASC 606 include a five-step process by which an entity will determine revenue recognition, depicting the transfer of goods or services to customers in amounts reflecting the payment to which an entity expects to be entitled in exchange for those goods or services. ASC 606 requires the Company to apply the following steps: (1) identify the contract with the customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when, or as, the Company satisfies the performance obligation.

 

Effective January 1, 2018, the Company adopted ASC 606 using the modified retrospective method for all of its contracts. Following the adoption of ASC 606, the Company continues to recognize revenue at a point-in-time when control of goods transfers to the customer. This is consistent with the Company’s previous revenue recognition accounting policy under which the Company recognized revenue when title and risk of loss pass to the customer and collectability was reasonably assured. In addition, ASU 606 did not impact the Company’s presentation of revenue on a gross or net basis.

 

The Company recognizes revenue primarily from sales of ethanol and its related co-products.

 

The Company has nine ethanol production facilities from which it produces and sells ethanol to its customers through Kinergy. Kinergy enters into sales contracts with ethanol customers under exclusive intercompany ethanol sales agreements with each of the Company’s nine ethanol plants. Kinergy also acts as a principal when it purchases third party ethanol which it resells to its customers. Finally, Kinergy has exclusive sales agreements with other third-party owned ethanol plants under which it sells their ethanol production for a fee plus the costs to deliver the ethanol to Kinergy’s customers. These sales are referred to as third-party agent sales. Revenue from these third-party agent sales is recorded on a net basis, with Kinergy recognizing its predetermined fees and any associated delivery costs.

 

The Company has nine ethanol production facilities from which it produces and sells co-products to its customers through PAP. PAP enters into sales contracts with co-product customers under exclusive intercompany co-product sales agreements with each of the Company’s nine ethanol plants.

 

The Company recognizes revenue from sales of ethanol and co-products at the point in time when the customer obtains control of such products, which typically occurs upon delivery depending on the terms of the underlying contracts. In some instances, the Company enters into contracts with customers that contain multiple performance obligations to deliver volumes of ethanol or co-products over a contractual period of less than 12 months. The Company allocates the transaction price to each performance obligation identified in the contract based on relative standalone selling prices and recognizes the related revenue as control of each individual product is transferred to the customer in satisfaction of the corresponding performance obligations.

 

-9

 

 

When the Company is the agent, the supplier controls the products before they are transferred to the customer because the supplier is primarily responsible for fulfilling the promise to provide the product, has inventory risk before the product has been transferred to a customer and has discretion in establishing the price for the product. When the Company is the principal, the Company controls the products before they are transferred to the customer because the Company is primarily responsible for fulfilling the promise to provide the products, has inventory risk before the product has been transferred to a customer and has discretion in establishing the price for the product.

 

The Company accounts for shipping and handling costs relating to contracts with customers as costs to fulfill its promise to transfer its products. Accordingly, the costs are classified as a component of cost of goods sold. See Note 2 for the Company’s revenue by type of contracts.

 

Estimates and Assumptions – The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates are required as part of determining the allowance for doubtful accounts, net realizable value of inventory, estimated lives of property and equipment, long-lived asset impairments, valuation allowances on deferred income taxes and the potential outcome of future tax consequences of events recognized in the Company’s financial statements or tax returns, and the valuation of assets acquired and liabilities assumed as a result of business combinations. Actual results and outcomes may materially differ from management’s estimates and assumptions.

 

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2.SEGMENTS.

 

The Company reports its financial and operating performance in two segments: (1) ethanol production, which includes the production and sale of ethanol, specialty alcohols and co-products, with all of the Company’s production facilities aggregated, and (2) marketing and distribution, which includes marketing and merchant trading for Company-produced ethanol, specialty alcohols and co-products and third-party ethanol.

 

The following tables set forth certain financial data for the Company’s operating segments (in thousands):

 

   Three Months Ended
September 30,
   Nine Months Ended
September 30,
 
   2018   2017   2018   2017 
                 
Net Sales                    
Production, recorded as gross:                    
Ethanol/alcohol sales  $216,788   $236,326   $670,304   $618,438 
Co-product sales   73,259    68,487    226,307    185,574 
Intersegment sales   518    639    1,531    1,138 
Total production sales   290,565    305,452    898,142    805,150 
                     
Marketing:                    
Ethanol/alcohol sales, gross  $79,877   $140,208   $282,940   $431,733 
Ethanol/alcohol sales, net   483    421    1,405    1,239 
Intersegment sales   2,201    2,334    6,757    6,135 
Total marketing sales   82,561    142,963    291,102    439,107 
                     
Intersegment eliminations   (2,719)   (2,973)   (8,288)   (7,273)
Net sales as reported  $370,407   $445,442   $1,180,956   $1,236,984 
                     
Cost of goods sold:                
Production  $295,574   $294,047   $914,638   $799,203 
Marketing and distribution   73,784    142,303    268,917    437,109 
Intersegment eliminations   (2,719)   (2,973)   (8,456)   (7,273)
Cost of goods sold as reported  $366,639   $433,377   $1,175,099   $1,229,039 
                 
Income (loss) before benefit for income taxes:                
Production  $(15,571)  $2,638   $(45,355)  $(15,981)
Marketing and distribution   7,416    (757)   18,095    (2,043)
Corporate activities   (1,149)   (2,422)   (6,708)   (5,940)
   $(9,304)  $(541)  $(33,968)  $(23,964)
Depreciation and amortization:                    
Production  $10,040   $9,841   $30,017   $27,703 
Corporate activities   177    237    618    783 
   $10,217   $10,078   $30,635   $28,486 
Interest expense:                
Production  $1,692   $1,850   $5,416   $4,061 
Marketing and distribution   344    342    1,042    953 
Corporate activities   2,157    1,634    6,417    4,143 
   $4,193   $3,826   $12,875   $9,157 

 

-11

 

 

The following table sets forth the Company’s total assets by operating segment (in thousands):

 

     
   September 30, 2018   December 31, 2017 
Total assets:          
Production  $545,360   $583,696 
Marketing and distribution   139,165    127,242 
Corporate assets   4,022    9,358 
   $688,547   $720,296 

 

3.INVENTORIES.

 

Inventories consisted primarily of bulk ethanol, specialty alcohols, corn, co-products, low-carbon and Renewable Identification Number (“RIN”) credits and unleaded fuel, and are valued at the lower-of-cost-or-net realizable value, with cost determined on a first-in, first-out basis. Inventory is net of valuation adjustments of $1,513,000 and $2,678,000 as of September 30, 2018 and December 31, 2017, respectively. Inventory balances consisted of the following (in thousands):

 

   September 30, 2018   December 31, 2017 
Finished goods  $33,525   $35,652 
Work in progress   7,753    8,807 
Raw materials   7,260    7,601 
Low-carbon and RIN credits   4,585    7,952 
Other   1,643    1,538 
Total  $54,766   $61,550 

 

4.DERIVATIVES.

 

The business and activities of the Company expose it to a variety of market risks, including risks related to changes in commodity prices. The Company monitors and manages these financial exposures as an integral part of its risk management program. This program recognizes the unpredictability of financial markets and seeks to reduce the potentially adverse effects that market volatility could have on operating results.

 

Commodity RiskCash Flow Hedges – The Company uses derivative instruments to protect cash flows from fluctuations caused by volatility in commodity prices for periods of up to twelve months in order to protect gross profit margins from potentially adverse effects of market and price volatility on ethanol sale and purchase commitments where the prices are set at a future date and/or if the contracts specify a floating or index-based price for ethanol. In addition, the Company hedges anticipated sales of ethanol to minimize its exposure to the potentially adverse effects of price volatility. These derivatives may be designated and documented as cash flow hedges and effectiveness is evaluated by assessing the probability of the anticipated transactions and regressing commodity futures prices against the Company’s purchase and sales prices. Ineffectiveness, which is defined as the degree to which the derivative does not offset the underlying exposure, is recognized immediately in cost of goods sold. For the three and nine months ended September 30, 2018 and 2017, the Company did not designate any of its derivatives as cash flow hedges.

 

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Commodity Risk – Non-Designated Hedges – The Company uses derivative instruments to lock in prices for certain amounts of corn and ethanol by entering into exchange-traded forward contracts for those commodities. These derivatives are not designated for special hedge accounting treatment. The changes in fair value of these contracts are recorded on the balance sheet and recognized immediately in cost of goods sold. The Company recognized losses of $991,000 and $483,000 as the changes in the fair values of these contracts for the three months ended September 30, 2018 and 2017, respectively. The Company recognized losses of $4,362,000 and $836,000 as the changes in the fair values of these contracts for the nine months ended September 30, 2018 and 2017, respectively.

 

Non Designated Derivative Instruments – The classification and amounts of the Company’s derivatives not designated as hedging instruments, and related cash collateral balances, are as follows (in thousands):

 

    As of September 30, 2018  
    Assets   Liabilities  
           
Type of Instrument   Balance Sheet Location     Fair Value   Balance Sheet Location       Fair Value  
Cash collateral balance   Other current assets   $ 7,752              
Commodity contracts   Derivative instruments   $ 1,954   Derivative instruments     $ 6,385  

 

    As of December 31, 2017  
    Assets   Liabilities  
           
Type of Instrument   Balance Sheet Location     Fair Value   Balance Sheet Location       Fair Value  
Cash collateral balance   Other current assets   $ 3,813              
Commodity contracts   Derivative instruments   $ 998   Derivative instruments     $ 2,307  

 

The classification and amounts of the Company’s recognized gains (losses) for its derivatives not designated as hedging instruments are as follows (in thousands):

 

          Realized Gains (Losses)  
          Three Months Ended September 30,  
Type of Instrument   Statements of Operations Location     2018     2017  
Commodity contracts   Cost of goods sold   $ 916   $ (1,576 )

  

          Unrealized Gains (Losses)  
          Three Months Ended September 30,  
Type of Instrument   Statements of Operations Location     2018     2017  
Commodity contracts   Cost of goods sold   $ (1,907 ) $ 1,093

 

          Realized Losses  
          Nine Months Ended September 30,  
Type of Instrument   Statements of Operations Location     2018     2017  
Commodity contracts   Cost of goods sold   $ (1,241 ) $ (4,495 )

 

          Unrealized Gains (Losses)  
          Nine Months Ended September 30,  
Type of Instrument   Statements of Operations Location     2018     2017  
Commodity contracts   Cost of goods sold   $ (3,121 ) $ 3,659

 

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5.DEBT.

 

Long-term borrowings are summarized as follows (in thousands):

 

   September 30, 2018   December 31, 2017 
Kinergy line of credit  $59,357   $49,477 
Pekin term loan   46,500    53,500 
Pekin revolving loan   30,000    32,000 
ICP term loan   18,000    22,500 
ICP revolving loan   14,000    18,000 
Parent notes payable   68,948    68,948 
    236,805    244,425 
Less unamortized debt discount   (870)   (1,409)
Less unamortized debt financing costs   (1,516)   (1,925)
Less short-term portion   (20,000)   (20,000)
Long-term debt  $214,419   $221,091 
           

Operating Lines of Credit – As of September 30, 2018, Kinergy, Pekin and ICP had additional borrowing availability under their credit facilities of $5,233,000, $2,000,000 and $4,000,000, respectively.

 

Pekin Term Loan – On March 30, 2018, Pacific Ethanol Pekin, LLC (“PE Pekin”), one of the Company’s subsidiaries, amended its term loan facility by reducing the amount of working capital it is required to maintain to not less than $13.0 million from March 31, 2018 through November 30, 2018 and not less than $16.0 million from December 1, 2018 and continuing at all times thereafter. In addition, a principal payment in the amount of $3.5 million due for May 2018 was deferred until the maturity date of the term loan. As of the filing of this report, the Company believes PE Pekin is in compliance with its working capital requirement.

 

Pacific Aurora Line of Credit – On March 30, 2018, Pacific Aurora, LLC, a majority owned subsidiary of the Company, terminated its revolving credit facility, which was unused during the three months ended March 31, 2018. As a result, the Company fully amortized its deferred financing fees of $0.3 million during the nine months ended September 30, 2018.

 

Distribution Restrictions – At September 30, 2018, there were approximately $207.2 million of net assets at the Company’s subsidiaries that were not available to be transferred to Pacific Ethanol, Inc. in the form of dividends, loans or advances due to restrictions contained in the credit facilities of the Company’s subsidiaries.

 

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6.COMMITMENTS AND CONTINGENCIES.

 

Sales Commitments – At September 30, 2018, the Company had entered into sales contracts with its major customers to sell certain quantities of ethanol and co-products. The Company had open ethanol indexed-price contracts for 199,732,000 gallons of ethanol as of September 30, 2018 and open fixed-price ethanol sales contracts totaling $74,502,000 as of September 30, 2018. The Company had open fixed-price co-product sales contracts totaling $53,365,000 and open indexed-price co-product sales contracts for 736,000 tons as of September 30, 2018. These sales contracts are scheduled to be completed over the next twelve months.

 

Purchase Commitments – At September 30, 2018, the Company had indexed-price purchase contracts to purchase 9,329,000 gallons of ethanol and fixed-price purchase contracts to purchase $5,614,000 of ethanol from its suppliers. The Company had fixed-price purchase contracts to purchase $13,038,000 of corn from its suppliers as of September 30, 2018. These purchase commitments are scheduled to be satisfied over the next twelve months.

 

Property Tax Assessment – In September 2016, the Company signed an agreement to finance and construct a 5 megawatt solar project at its Madera facility. The amount financed is for up to $10,000,000, to be amortized over twenty years as part of the facility’s property tax assessments. As of September 30, 2018, the Company had incurred approximately $9,600,000 in project costs, which is recorded in construction in progress and in other liabilities in the accompanying consolidated balance sheets. The Company expects to pay approximately an additional $900,000 per year in connection with its property tax payments, which includes an interest component based upon a 5.6% interest rate on the outstanding balance of the assessment.

 

Litigation – General The Company is subject to various claims and contingencies in the ordinary course of its business, including those related to litigation, business transactions, employee-related matters, environmental regulations and others. When the Company is aware of a claim or potential claim, it assesses the likelihood of any loss or exposure. If it is probable that a loss will result and the amount of the loss can be reasonably estimated, the Company will record a liability for the loss. If the loss is not probable or the amount of the loss cannot be reasonably estimated, the Company discloses the claim if the likelihood of a potential loss is reasonably possible and the amount involved could be material. While there can be no assurances, the Company does not expect that any of its pending legal proceedings will have a material impact on the Company’s financial condition or results of operations.

 

The Company assumed certain legal matters which were ongoing at July 1, 2015, the date of the Company’s acquisition of Aventine Renewable Energy Holdings, Inc. (“PE Central”). Among them were lawsuits between Aventine Renewable Energy, Inc. (now known as Pacific Ethanol Pekin, LLC) and Glacial Lakes Energy, Aberdeen Energy and Redfield Energy, together, the “Defendants,” in which PE Pekin sought damages for breach of termination agreements that wound down ethanol marketing arrangements between PE Pekin and each of the Defendants. In February and March 2017, the Company and the Defendants entered into settlement agreements and the Defendants paid in cash to the Company $3.9 million in final resolution of these matters. The Company did not assign any value to the claims against the Defendants in its accounting for the PE Central acquisition as of July 1, 2015. The Company recorded a gain, net of legal fees, of $3.6 million upon receipt of the cash settlement and recognized the gain as a reduction to selling, general and administrative expenses in the consolidated statements of operations for the nine months ended September 30, 2017.

 

7.PENSION AND RETIREMENT BENEFIT PLANS.

 

The Company sponsors a defined benefit pension plan (the “Retirement Plan”) and a health care and life insurance plan (the “Postretirement Plan”). The Company assumed the Retirement Plan and the Postretirement Plan as part of its acquisition of PE Central on July 1, 2015.

 

The Retirement Plan is noncontributory, and covers only “grandfathered” unionized employees at the Company’s Pekin, Illinois facility who fulfill minimum age and service requirements. Benefits are based on a prescribed formula based upon the employee’s years of service. The Retirement Plan, which is part of a collective bargaining agreement, covers only union employees hired prior to November 1, 2010.

 

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The Company uses a December 31 measurement date for its Retirement Plan. The Company’s funding policy is to make the minimum annual contribution required by applicable regulations. As of December 31, 2017, the Retirement Plan’s accumulated projected benefit obligation was $19.7 million, with a fair value of plan assets of $14.0 million. The underfunded amount of $5.7 million is recorded on the Company’s consolidated balance sheet in other liabilities.

 

Of the net periodic expense for the Retirement Plan and Postretirement Plan, the Company recognizes the service cost component in cost of goods sold and the interest cost, expected return on plan assets and amortization of gain (loss) in other income (expense), net.

 

The Company’s net periodic Retirement Plan costs are as follows (in thousands):

 

   Three Months Ended
September 30,
   Nine Months Ended
September 30,
 
   2018   2017   2018   2017 
                 
Interest cost  $174   $98   $522   $293 
Service cost   106    188    318    563 
Expected return on plan assets   (204)   (169)   (612)   (506)
Net periodic expense  $76   $117   $228   $350 

 

The Postretirement Plan provides postretirement medical benefits and life insurance to certain “grandfathered” unionized employees. Employees hired after December 31, 2000 are not eligible to participate in the Postretirement Plan. The Postretirement Plan is contributory, with contributions required at the same rate as active employees. Benefit eligibility under the plan reduces at age 65 from a defined benefit to a defined dollar cap based upon years of service. As of December 31, 2017, the Postretirement Plan’s accumulated projected benefit obligation was $5.6 million and is recorded on the Company’s consolidated balance sheet in other liabilities. The Company’s funding policy is to make the minimum annual contribution required by applicable regulations.

 

The Company’s net periodic Postretirement Plan costs are as follows (in thousands):

 

   Three Months Ended
September 30,
   Nine Months Ended  
September 30,
 
   2018   2017   2018   2017 
                 
Interest cost  $46   $21   $138   $63 
Service cost   2    50    6    150 
Amortization of (gain) loss   33    33    99    99 
Net periodic expense  $81   $104   $243   $312 

 

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8.       FAIR VALUE MEASUREMENTS.

 

The fair value hierarchy prioritizes the inputs used in valuation techniques into three levels, as follows:

 

Level 1 – Observable inputs – unadjusted quoted prices in active markets for identical assets and liabilities;

 

Level 2 – Observable inputs other than quoted prices included in Level 1 that are observable for the asset or liability through corroboration with market data; and

 

Level 3 – Unobservable inputs – includes amounts derived from valuation models where one or more significant inputs are unobservable. For fair value measurements using significant unobservable inputs, a description of the inputs and the information used to develop the inputs is required along with a reconciliation of Level 3 values from the prior reporting period.

 

Pooled separate accounts – Pooled separate accounts invest primarily in domestic and international stocks, commercial paper or single mutual funds. The net asset value is used as a practical expedient to determine fair value for these accounts. Each pooled separate account provides for redemptions by the Retirement Plan at reported net asset values per share, with little to no advance notice requirement, therefore these funds are classified within Level 2 of the valuation hierarchy.

 

Other Derivative Instruments – The Company’s other derivative instruments consist of commodity positions. The fair values of the commodity positions are based on quoted prices on the commodity exchanges and are designated as Level 1 inputs.

 

The following table summarizes recurring fair value measurements by level at September 30, 2018 (in thousands):

                 
   Fair             
   Value   Level 1   Level 2   Level 3 
Assets:                
Derivative instruments  $1,954   $1,954   $   $ 
Liabilities:                    
Derivative instruments  $(6,385)  $(6,385)  $   $ 

 

9.EARNINGS PER SHARE.

 

The following tables compute basic and diluted earnings per share (in thousands, except per share data):

 

   Three Months Ended September 30, 2018 
             
   Loss
Numerator
   Shares Denominator   Per-Share Amount 
Net loss attributed to Pacific Ethanol, Inc.  $(7,514)          
Less: Preferred stock dividends   (319)          
Basic and diluted loss per share:               
Loss available to common stockholders  $(7,833)   43,299   $(0.18)

 

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   Three Months Ended September 30, 2017 
     
   Loss
Numerator
   Shares Denominator   Per-Share Amount 
Net loss attributed to Pacific Ethanol, Inc.  $(202)          
Less: Preferred stock dividends   (319)          
Basic and diluted loss per share:               
Loss available to common stockholders  $(521)   42,475   $(0.01)

 

   Nine Months Ended September 30, 2018 
     
   Loss
Numerator
   Shares Denominator   Per-Share Amount 
Net loss attributed to Pacific Ethanol, Inc.  $(28,263)          
Less: Preferred stock dividends   (946)          
Basic and diluted loss per share:               
Loss available to common stockholders  $(29,209)   43,171   $(0.68)

 

   Nine Months Ended September 30, 2017 
     
   Loss
Numerator
   Shares Denominator   Per-Share Amount 
Net loss attributed to Pacific Ethanol, Inc.  $(21,679)          
Less: Preferred stock dividends   (946)          
Basic and diluted loss per share:               
Loss available to common stockholders  $(22,625)   42,358   $(0.53)

 

There were an aggregate of 425,000 and 635,000 potentially dilutive weighted-average shares from convertible securities outstanding for the three and nine months ended September 30, 2018, respectively. These convertible securities were not considered in calculating diluted net loss per share for the three and nine months ended September 30, 2018, as their effect would have been anti-dilutive.

 

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ITEM 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

The following discussion and analysis should be read in conjunction with our consolidated financial statements and notes to consolidated financial statements included elsewhere in this report. This report and our consolidated financial statements and notes to consolidated financial statements contain forward-looking statements, which generally include the plans and objectives of management for future operations, including plans and objectives relating to our future economic performance and our current beliefs regarding revenues we might generate and profits we might earn if we are successful in implementing our business and growth strategies. The forward-looking statements and associated risks may include, relate to or be qualified by other important factors, including:

 

fluctuations in the market price of ethanol and its co-products;

 

fluctuations in the costs of key production input commodities such as corn and natural gas;

 

the projected growth or contraction in the ethanol and co-product markets in which we operate;

 

our strategies for expanding, maintaining or contracting our presence in these markets;

 

anticipated trends in our financial condition and results of operations; and

 

our ability to distinguish ourselves from our current and future competitors.

 

You are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date of this report, or in the case of a document incorporated by reference, as of the date of that document. We do not undertake to update, revise or correct any forward-looking statements, except as required by law.

 

Any of the factors described immediately above, or referenced from time to time in our filings with the Securities and Exchange Commission or in the “Risk Factors” section below could cause our financial results, including our net income or loss or growth in net income or loss to differ materially from prior results, which in turn could, among other things, cause the price of our common stock to fluctuate substantially.

 

Overview

 

We are a leading producer and marketer of low-carbon renewable fuels in the United States.

 

We operate nine strategically-located production facilities. Four of our plants are in the Western states of California, Oregon and Idaho, and five of our plants are located in the Midwestern states of Illinois and Nebraska. We are the sixth largest producer of ethanol in the United States based on annualized volumes. Our plants have a combined production capacity of 605 million gallons per year. We market all the ethanol, specialty alcohols and co-products produced at our plants as well as ethanol produced by third parties. On an annualized basis, we market nearly 1.0 billion gallons of ethanol and over 3.0 million tons of co-products on a dry matter basis. Our business consists of two operating segments: a production segment and a marketing segment.

 

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Our mission is to advance our position and significantly increase our market share as a leading producer and marketer of low-carbon renewable fuels and high-quality alcohol products in the United States. We intend to accomplish this goal in part by expanding our ethanol production capacity and distribution infrastructure, accretive acquisitions, lowering the carbon intensity of our ethanol, extending our marketing business into new regional and international markets, and implementing new technologies to promote higher production yields and greater efficiencies.

 

Production Segment

 

We produce ethanol, specialty alcohols and co-products at our production facilities described below. Our plants located on the West Coast are near their respective fuel and feed customers, offering significant timing, transportation cost and logistical advantages. Our plants located in the Midwest are in the heart of the Corn Belt, benefit from low-cost and abundant feedstock production and allow for access to many additional domestic markets. In addition, our ability to load unit trains from our plants located in the Midwest, and barges from our Pekin, Illinois plants, allows for greater access to international markets.

 

We wholly-own all of our plants located on the West Coast and the three plants in Pekin, Illinois. We own approximately 74% of the two plants in Aurora, Nebraska as well as the grain elevator adjacent to those properties and related grain handling assets, including the outer rail loop, and the real property on which they are located, through Pacific Aurora, LLC, or Pacific Aurora, an entity owned approximately 26% by Aurora Cooperative Elevator Company.

 

Facility Name

Facility Location

Estimated Annual
Capacity
(gallons)

Magic Valley Burley, ID 60,000,000
Columbia Boardman, OR 40,000,000
Stockton Stockton, CA 60,000,000
Madera Madera, CA 40,000,000
Aurora West Aurora, NE 110,000,000
Aurora East Aurora, NE 45,000,000
Pekin Wet Pekin, IL 100,000,000
Pekin Dry Pekin, IL 60,000,000
Pekin ICP Pekin, IL 90,000,000

 

We produce ethanol co-products at our production facilities such as wet distillers grains, or WDG, dried distillers grains with solubles, or DDGS, wet and dry corn gluten feed, condensed distillers solubles, corn gluten meal, corn germ, corn oil, dried yeast and CO2.

 

Marketing Segment

 

We market ethanol, specialty alcohols and co-products produced by our facilities and market ethanol produced by third parties. We have extensive customer relationships throughout the Western and Midwestern United States. Our ethanol customers are integrated oil companies and gasoline marketers who blend ethanol into gasoline. Our customers depend on us to provide a reliable supply of ethanol, and manage the logistics and timing of delivery with very little effort on their part. Our customers collectively require ethanol volumes in excess of the supplies we produce at our production facilities. We secure additional ethanol supplies from third-party plants in California and other third-party suppliers in the Midwest where a majority of ethanol producers are located. We arrange for transportation, storage and delivery of ethanol purchased by our customers through our agreements with third-party service providers in the Western United States as well as in the Midwest from a variety of sources.

 

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We market our distillers grains and other feed co-products to dairies and feedlots, in many cases located near our ethanol plants. These customers use our feed co-products for livestock as a substitute for corn and other sources of starch and protein. We sell our corn oil to poultry and biodiesel customers. We do not market co-products from other ethanol producers.

 

See “Note 2 – Segments” to our Notes to Consolidated Financial Statements included elsewhere in this report for financial information about our business segments.

 

Outlook

  

Our results for the third quarter and first nine months of 2018 reflect a compressed margin environment primarily resulting from high industry-wide inventory levels. High inventory levels resulted in part from escalating trade positioning between the United States and China, which resulted in early April in additional tariffs placed on United States ethanol shipped to China, halting United States ethanol exports to China. In addition, the Environmental Protection Agency’s, or EPA’s, continued practice of granting small refinery exemptions from the Renewable Fuel Standard, or RFS, negatively impacted ethanol margins. Higher corn freight costs and resulting corn basis costs into our Western facilities also reduced our production margins. We have reduced our production levels and are running at approximately 90% operating capacity across our portfolio of production assets.

 

Industry fundamentals remain strong and should support better margins in 2019. Ethanol remains a low-cost, high-value, low-carbon renewable fuel and source of octane. Moreover, blending ethanol into gasoline reduces the price of gasoline to consumers. We believe these compelling blend economics will drive higher domestic and international blend rates and result in an improved margin environment.

 

At President Trump’s direction, the EPA commenced a formal rulemaking process, with an expected completion by summer 2019, to allow year-round sales of E15 nationwide. This is a significant industry growth opportunity that could result in up to 7.0 billion gallons of additional annual ethanol demand based on the current market for gasoline. Although the roll-out of commercial E15 availability will take time, year-round availability provides an important growth path for the United States ethanol industry and we expect sales of E15 to grow materially in 2019 given the cost and environmental advantages of higher ethanol blends. Following the President’s announcement, two large fuel retail chains announced large expansion plans for E15 distribution and we expect to hear additional similar announcements soon.

 

With RIN prices trading near five-year lows, we see no rationale for the EPA to grant additional small refinery economic hardship exemptions. We are actively engaged, including through industry trade associations, with the EPA to be more judicious in granting these exemptions and, when granted, to reallocate those gallons to all other obligated parties.

 

International demand for ethanol set records in 2017 and remains on pace to exceed those records in 2018, with approximately 30 countries having renewable fuel standards or targets. United States ethanol exports from January through August 2018 reached 1.20 billion gallons, up substantially from the same period in 2017 and on pace to significantly exceed the 1.37 billion gallons exported for all of 2017. More countries are importing ethanol from the United States as it represents a low-cost source of high-octane and low-carbon transportation fuel.

 

The Trump administration recently acted to preserve tariff-free treatment for ethanol exported to Canada and Mexico. Canada represents the second-largest export market while Mexico, a small export market for the United States, is poised to increase ethanol use as a cost-effective and environmentally favorable substitute for MTBE. United States ethanol exports to both countries reflect year-over-year growth thus far in 2018.

 

Prior to the halt of United States exports to China, China had returned earlier in the year as a significant buyer of United States-sourced ethanol, supporting its announced 10% blending requirement by 2020. If China continues to pursue this goal, even while rapidly increasing its own domestic ethanol production, it will require significant ethanol imports, ultimately supporting the continued growth in overall international demand for ethanol. We expect total United States exports for 2018 to reach a record high of between 1.60 and 1.70 billion gallons, which represents around a 20% increase from 2017 levels, and we expect additional export growth in 2019.

 

Carbon values in our California and Oregon markets remain strong, resulting in robust premiums for our lower-carbon ethanol. This week, California carbon prices reached record highs of more than $190 per metric ton.

 

Leading oil and gas companies continue to invest in ethanol assets. Recently, Valero Renewable Fuels Company announced the purchase of three ethanol plants, demonstrating a positive long-term view of ethanol. In addition, the acquisition provides an updated indication of the value of ethanol production assets.

 

We continue to focus on implementing initiatives and investing in our assets to reduce costs, improve yields and carbon scores, and build long-term value. We are engaged in several plant-level capital projects with near-term paybacks.

 

We completed our 5.0-megawatt solar photovoltaic power system at our Madera facility. The system is operating at a 3.5-megawatt level and we anticipate full 5.0-megawatt production by year-end, once PG&E, our electricity provider, has completed its final upgrades to its adjacent substation. We expect the system to reduce our utility costs by approximately $1.0 million annually and lower our carbon score.

 

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Our 3.5-megawatt cogeneration system at our Stockton plant is now fully installed. We are currently engaged in start-up operations and anticipate the system will be at target performance by year-end. The system converts process waste gas and natural gas into electricity and steam, reducing energy costs by up to $4.0 million per year and lowering carbon and nitrogen oxide emissions.

 

Airgas continues to construct a liquid CO2 production plant adjacent to our Stockton facility. We expect commercial operations will commence in early 2019 and that we will begin generating revenues from this arrangement in the first quarter.

 

During the third quarter, we received a new cellulosic ethanol pathway from the California Air Resources Board for cellulosic ethanol produced at our Stockton plant. We continue to generate D3 RINs and await final EPA approval of our cellulosic ethanol pathways for our Madera and Magic Valley plants. These pathways will add to our premium pricing for cellulosic ethanol and once approved, production from these three plants will generate additional combined EBITDA of $2.0 million annually based on the current carbon market, of which our Stockton plant is expected to generate approximately $0.5 million of incremental EBITDA.

 

Our capital expenditures for the third quarter totaled $3.5 million and were primarily related to plant improvement initiatives. Our cumulative capital expenditures through the third quarter were $10.9 million. In light of weak market conditions, we have adjusted a number of capital projects and expect to limit our fourth quarter capital expenditures to approximately $3.0 million, well below our prior full-year guidance.

 

Our focus is on delivering additional value by leveraging our diverse base of existing production and marketing assets to capitalize on positive macro trends. Our strategy is built around our strategically-located bio-refineries, which enable us to serve multiple markets; the diversity of our production, geography, technology, feedstocks and logistics, which helps us mitigate exposure to commodity price risks within fuel markets; and our focus on evaluating and investing in plant improvement and other initiatives to increase production and operating efficiencies and yields. We are also focused on reducing costs at both the corporate and operating levels, further diversifying our sales through additional high-protein feed and alcohol products, and undertaking new initiatives to lower our carbon scores for our valuable low-carbon fuel markets.

 

Critical Accounting Policies

 

The preparation of our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, requires us to make judgments and estimates that may have a significant impact upon the portrayal of our financial condition and results of operations. We believe that of our significant accounting policies, the following require estimates and assumptions that require complex, subjective judgments by management that can materially impact the portrayal of our financial condition and results of operations: revenue recognition; impairment of long-lived assets; valuation of allowance for deferred taxes; derivative instruments; accounting for business combinations; and allowance for doubtful accounts. These significant accounting principles are more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in our Annual Report on Form 10-K for the year ended December 31, 2017.

 

Results of Operations

 

The following selected financial information should be read in conjunction with our consolidated financial statements and notes to our consolidated financial statements included elsewhere in this report, and the other sections of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in this report.

 

Certain performance metrics that we believe are important indicators of our results of operations include:

 

  

Three Months Ended

September 30,

  

Percentage

  

Nine Months Ended

September 30,

  

Percentage 

 
   2018   2017   Variance   2018   2017   Variance 
Production gallons sold (in millions)   139.9    141.8    (1.3)%   425.1    374.0    13.7%
Third party gallons sold (in millions)   72.3    108.2    (33.2)%   247.2    335.2    (26.3)%
Total gallons sold (in millions)   212.2    250.0    (15.1)%   672.3    709.2    (5.2)%
Total gallons produced (in millions)
   138.7    145.5    (4.7)%   424.1    385.1    10.1%
Production capacity utilization   91%   95%   (4.2)%   94%   94%          —%
Average sales price per gallon
  $1.60   $1.69    (5.3)%  $1.61   $1.66    (3.0)%
Corn cost per bushel – CBOT equivalent
  $3.63   $3.69    (1.6)%  $3.67   $3.67    

%
Average basis (1)  $0.21   $0.11    90.9%  $0.26   $0.21    23.8%
Delivered cost of corn  $3.84   $3.80    1.1%  $3.93   $3.88    1.3%
                               
Total co-product tons sold (in thousands)   773.2    803.4    (3.8)%   2,365.2    2,223.2    6.4%

Co-product revenues as % of delivered cost of corn(2)

   35.8%   34.0%   5.3%   36.2%   34.2%   5.8%
Average CBOT ethanol price per gallon  $1.35   $1.55    (12.9)%  $1.41   $1.54    (8.4)%
Average CBOT corn price per bushel  $3.53   $3.59    (1.7)%  $3.68   $3.64    1.1%

 

 

(1)Corn basis represents the difference between the immediate cash price of delivered corn and the future price of corn for Chicago delivery.

(2)Co-product revenues as a percentage of delivered cost of corn shows our yield based on sales of co-products, including WDG and corn oil, generated from ethanol we produced.

 

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Net Sales, Cost of Goods Sold and Gross Profit

 

The following table presents our net sales, cost of goods sold and gross profit in dollars and gross profit as a percentage of net sales (in thousands, except percentages):

 

  

Three Months Ended September 30,

  

Variance in

  

Nine Months Ended

September 30,

  

Variance in

 
  

2018

  

2017

  

Dollars

  

Percent

  

2018

  

2017

  

Dollars

  

Percent

 
                                 
Net sales  $370,407   $445,442   $(75,035)   (16.8)%  $1,180,956   $1,236,984   $(56,028)   (4.5)%
Cost of goods sold   366,639    433,377    (66,738)   (15.4)%   1,175,099    1,229,039    (53,940)   (4.4)%
Gross profit  $3,768   $12,065   $(8,297)   (68.8)%  $5,857   $7,945   $(2,088)   (26.3)%
Percentage of net sales   1.0%   2.7%             0.5%   0.6%          

 

Net Sales

 

The decrease in our net sales for the three and nine months ended September 30, 2018 as compared to the same period in 2017 was primarily due to a decrease in our third party gallons sold as well as a decrease in our average sales price per gallon. We sold fewer third party gallons as we deliberately focused our third party ethanol sales in regions where we have either a stronger presence around our own production assets or more favorable margins.

 

Three Months Ended September 30, 2018

 

On a consolidated basis, our average sales price per gallon declined $0.09, or 5%, to $1.60 for the three months ended September 30, 2018 as compared to $1.69 for the same period in 2017. The average Chicago Board of Trade, or CBOT, ethanol price per gallon, however, declined 13% to $1.35 for the three months ended September 30, 2018 compared to an average CBOT ethanol price per gallon of $1.55 for the same period in 2017.

 

Production Segment

 

Net sales of ethanol from our production segment declined by $19.5 million, or 8%, to $216.8 million for the three months ended September 30, 2018 as compared to $236.3 million for the same period in 2017. Our total volume of production ethanol gallons sold declined by 1.9 million gallons, or 1%, to 139.9 million gallons for the three months ended September 30, 2018 as compared to 141.8 million gallons for the same period in 2017. Our production segment’s average sales price per gallon declined 7% to $1.53 for the three months ended September 30, 2018 compared to our production segment’s average sales price per gallon of $1.65 for the same period in 2017. At our production segment’s average sales price per gallon of $1.53 for the three months ended September 30, 2018, we realized $2.9 million less in net sales from our production segment from the 1.9 million fewer gallons of produced ethanol sold in the three months ended September 30, 2018 as compared to the same period in 2017. The decline of $0.12 in our production segment’s average sales price per gallon for the three months ended September 30, 2018 as compared to the same period in 2017 reduced our net sales of ethanol from our production segment by $16.6 million.

 

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Net sales of co-products increased $4.8 million, or 7%, to $73.3 million for the three months ended September 30, 2018 as compared to $68.5 million for the same period in 2017. Our total volume of co-products sold declined by 30.2 thousand tons, or 4%, to 773.2 thousand tons for three months ended September 30, 2018 from 803.4 thousand tons for the same period in 2017, and our average sales price per ton increased to $94.75 for the three months ended September 30, 2018 from $85.25 for the same period in 2017. The increase of $9.50, or 11%, in our average sales price per ton for the three months ended September 30, 2018 as compared to the same period in 2017 increased net sales of co-products by $7.6 million, however, at our average sales price per ton of $94.75 for the three months ended September 30, 2018, we realized $2.8 million less in net sales from the 30.2 thousand ton decline in co-products sold in the three months ended September 30, 2018 as compared to the same period in 2017.

 

Marketing Segment

 

Net sales of ethanol from our marketing segment declined by $60.3 million, or 43%, to $79.9 million for the three months ended September 30, 2018 as compared to $140.2 million for the same period in 2017. Our total volume of ethanol gallons sold by our marketing segment declined by 37.8 million gallons, or 15%, to 212.2 million gallons for the three months ended September 30, 2018 as compared to 250.0 million gallons for the same period in 2017. Of these amounts, our marketing segment sold 35.9 million fewer third party gallons and 1.9 million fewer production gallons.

 

The decline in production gallons sold by our marketing segment resulted in a decline of $0.1 million in net sales generated by our marketing segment, which were eliminated upon consolidation.

 

Our marketing segment’s average sales price per gallon increased $0.02, or 1%, to $1.72 for the three months ended September 30, 2018 as compared to $1.70 for the same period in 2017. At our marketing segment’s average sales price per gallon of $1.72 for the three months ended September 30, 2018, we realized $64.9 million less in net sales from our marketing segment from the 37.8 million fewer gallons sold in the three months ended September 30, 2018 as compared to the same period in 2017. The increase of $0.02 in our marketing segment’s average sales price per gallon for the three months ended September 30, 2018 as compared to the same period in 2017 increased our net sales from ethanol sold by our marketing segment by $4.6 million.

 

Nine Months Ended September 30, 2018

 

On a consolidated basis, our average sales price per gallon declined $0.05, or 3%, to $1.61 for the nine months ended September 30, 2018 compared to our average sales price per gallon of $1.66 for the same period in 2017. The average CBOT ethanol price per gallon declined 8% to $1.41 for the nine months ended September 30, 2018 compared to an average CBOT ethanol price per gallon of $1.54 for the same period in 2017.

 

Production Segment

 

Net sales of ethanol from our production segment increased by $51.9 million, or 8%, to $670.3 million for the nine months ended September 30, 2018 as compared to $618.4 million for the same period in 2017. Our total volume of production ethanol gallons sold increased by 51.1 million gallons, or 14%, to 425.1 million gallons for the nine months ended September 30, 2018 as compared to 374.0 million gallons for the same period in 2017. Our production segment’s average sales price per gallon declined 5% to $1.56 for the nine months ended September 30, 2018 compared to our production segment’s average sales price per gallon of $1.64 for the same period in 2017. At our production segment’s average sales price per gallon of $1.56 for the nine months ended September 30, 2018, we generated $80.0 million in additional net sales from our production segment from the 51.1 million additional gallons of produced ethanol sold in the nine months ended September 30, 2018 as compared to the same period in 2017. The decline of $0.08 in our production segment’s average sales price per gallon for the nine months ended September 30, 2018 as compared to the same period in 2017 reduced our net sales of ethanol from our production segment by $28.1 million.

 

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Net sales of co-products increased $40.7 million, or 22%, to $226.3 million for the nine months ended September 30, 2018 as compared to $185.6 million for the same period in 2017. Our total volume of co-products sold increased by 142.0 thousand tons, or 6%, to 2,365.2 thousand tons for nine months ended September 30, 2018 from 2,223.2 thousand tons for the same period in 2017, and our average sales price per ton increased to $95.68 for the nine months ended September 30, 2018 from $83.47 for the same period in 2017. At our average sales price per ton of $95.68 for the nine months ended September 30, 2018, we generated $13.6 million in additional net sales from the 142.0 thousand tons of additional co-products sold in the nine months ended September 30, 2018 as compared to the same period in 2017. The increase of $12.21, or 15%, in our average sales price per ton for the nine months ended September 30, 2018 as compared to the same period in 2017 increased net sales of co-products by $27.1 million.

 

Marketing Segment

 

Net sales of ethanol from our marketing segment declined by $148.8 million, or 34%, to $282.9 million for the nine months ended September 30, 2018 as compared to $431.7 million for the same period in 2017. Our total volume of ethanol gallons sold by our marketing segment declined by 36.9 million gallons, or 5%, to 672.3 million gallons for the nine months ended September 30, 2018 as compared to 709.2 million gallons for the same period in 2017. Of these amounts, we sold 88.0 million fewer third party gallons, which was partially offset by 51.1 million additional production gallons sold by our marketing segment.

 

The increase in production gallons sold by our marketing segment resulted in an increase of $0.6 million in net sales generated by our marketing segment, which were eliminated upon consolidation.

 

Our marketing segment’s average sales price per gallon declined $0.13, or 8%, to $1.54 for the nine months ended September 30, 2018 as compared to $1.67 for the same period in 2017. At our marketing segment’s average sales price per gallon of $1.54 for the nine months ended September 30, 2018, we realized $56.8 million less in net sales from our marketing segment from the 36.9 million fewer gallons sold in the nine months ended September 30, 2018 as compared to the same period in 2017. Further, the decline of $0.13 in our marketing segment’s average sales price per gallon for the nine months ended September 30, 2018 as compared to the same period in 2017 reduced our net sales from ethanol sold by our marketing segment by $91.4 million.

 

Cost of Goods Sold and Gross Profit

 

Our consolidated gross profit declined primarily due to lower commodity margins in the three and nine months ended September 30, 2018 compared to the same periods in 2017. Higher corn freight costs and resulting corn basis costs compressed production margins. In addition, ethanol margins were negatively impacted by the EPA’s continued practice of granting small refinery exemptions from the Renewable Fuel Standard and trade tariffs that have halted United States ethanol exports to China, resulting in higher industry-wide inventory levels which further pressured margins.

 

Three Months Ended September 30, 2018

 

Our consolidated gross profit declined to $3.8 million for the three months ended September 30, 2018 as compared to $12.1 million for the same period in 2017, representing a gross margin of 1.0% for the three months ended September 30, 2018 as compared to 2.7% for the same period in 2017.

 

-25

 

 

Production Segment

 

Our production segment’s gross profit from external sales declined by $16.4 million to a gross loss of $5.0 million for the three months ended September 30, 2018 as compared to a gross profit of $11.4 million for the same period in 2017. Of this decline, $16.5 million is attributable to our production segment’s lower margins for the three months ended September 30, 2018 as compared to the same period in 2017, partially offset by $0.1 million attributable to lower production volumes at negative production margins for the three months ended September 30, 2018 as compared to the same period in 2017.

 

Marketing Segment

 

Our marketing segment’s gross profit improved by $8.1 million to $8.8 million for the three months ended September 30, 2018 as compared to $0.7 million for the same period in 2017. Of this increase, $16.1 million is attributable to our marketing segment’s improved margins per gallon for the three months ended September 30, 2018 as compared to the same period in 2017, partially offset by $8.0 million in lower gross profit attributable to the 35.9 million gallon reduction in third-party marketing volumes for the three months ended September 30, 2018 as compared to the same period in 2017.

 

Nine Months Ended September 30, 2018

 

Our consolidated gross profit declined to $5.9 million for the nine months ended September 30, 2018 as compared to $7.9 million for the same period in 2017, representing a gross margin of 0.5% for the nine months ended September 30, 2018 as compared to 0.6% for the same period in 2017.

 

Production Segment

 

Our production segment’s gross profit from external sales declined by $22.4 million to a gross loss of $16.5 million for the nine months ended September 30, 2018 as compared to a gross profit of $5.9 million for the same period in 2017. Of this decline, $20.4 million is attributable to our production segment’s lower margins for the nine months ended September 30, 2018 as compared to the same period in 2017, and $2.0 million is attributable to increased production volumes at negative production margins for the nine months ended September 30, 2018 as compared to the same period in 2017.

 

Gross profit generated by our production segment was negatively impacted by $4.1 million in higher than expected repairs and maintenance expense at our Pekin, Illinois wet mill facility for the nine months ended September 30, 2018. We have experienced larger than anticipated expenses since the second half of 2015 related initially to the repair, and then replacement, of two package boilers that failed shortly prior to our acquisition of our Midwest assets in 2015. We have resolved these boiler issues, which totaled $11.0 million in 2017, and anticipate that wet mill boiler expenses associated with these issues will be eliminated going forward. We continue to pursue a claim against the boiler manufacturer which will result, however, in ongoing litigation expenses.

 

Marketing Segment

 

Our marketing segment’s gross profit improved by $20.4 million to $22.4 million for the nine months ended September 30, 2018 as compared to $2.0 million for the same period in 2017. Of this increase, $28.3 million is attributable to our marketing segment’s improved margins for the nine months ended September 30, 2018 as compared to the same period in 2017, partially offset by $7.9 million in lower gross profit attributable to the 88.0 million gallon reduction in marketing volumes for the nine months ended September 30, 2018 as compared to the same period in 2017.

 

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Selling, General and Administrative Expenses

 

The following table presents our selling, general and administrative, or SG&A, expenses in dollars and as a percentage of net sales (in thousands, except percentages):

 

  

Three Months Ended September 30,

  

Variance in

  

Nine Months Ended September 30,

  

Variance in

 
  

2018

  

2017

  

Dollars

  

Percent

  

2018

  

2017

  

Dollars

  

Percent

 
Selling, general and administrative expenses  $8,970   $8,720   $250    2.9%  $27,183   $22,932   $4,251    18.5%
Percentage of net sales   2.4%   2.0%             2.3%   1.9%          

 

Our SG&A expenses remained relatively flat for the three months ended September 30, 2018 as compared to the same period in 2017.

 

Our SG&A expenses increased $4.3 million to $27.2 million for the nine months ended September 30, 2018 as compared to $22.9 million for the same period in 2017. The increase in SG&A expenses is primarily due to $3.6 million in one-time gains associated with legal matters resolved in the prior year that reduced our SG&A expenses for 2017. In addition, our SG&A expenses for the nine months ended September 30, 2018 include expenses related to the operation of our ICP facility that were only present for the three months ended September 30, 2017 as the acquisition occurred on July 3, 2017. We anticipate SG&A expenses will total approximately $36.0 million for all of 2018.

 

Interest Expense

 

The following table presents our interest expense in dollars and as a percentage of net sales (in thousands, except percentages):

 

  

Three Months Ended September 30,

  

Variance in

  

Nine Months Ended September 30,

  

Variance in

 
  

2018

  

2017

  

Dollars

  

Percent

  

2018

  

2017

  

Dollars

  

Percent

 
Interest expense  $4,193   $3,826   $367    9.6%  $12,875   $9,157   $3,718    40.6%
Percentage of net sales   1.1%   0.9%             1.1%   0.7%          

 

Interest expense increased $0.4 million to $4.2 million for the three months ended September 30, 2018 from $3.8 million for the same period in 2017. Interest expense increased $3.7 million to $12.9 million for the nine months ended September 30, 2018 from $9.2 million for the same period in 2017. The increase in interest expense is primarily due to additional borrowings related to our acquisition of ICP as of July 3, 2017, and higher interest rates on our senior notes, which increased in accordance with the note terms. In addition, during the nine months ended September 30, 2018, we realized higher interest expense of $0.3 million due to accelerated amortization of deferred financing costs associated with our termination of Pacific Aurora’s line of credit.

 

-27

 

 

Loss Available to Common Stockholders

 

The following table presents our loss available to common stockholders in dollars and as a percentage of net sales (in thousands, except percentages):

 

  

Three Months Ended September 30,

  

Variance in

  

Nine Months Ended September 30,

  

Variance in

 
  

2018

  

2017

  

Dollars

  

Percent

  

2018

  

2017

  

Dollars

  

Percent

 
Loss available to common stockholders  $7,833   $521   $7,312    1,403.5%  $29,209   $22,625   $6,584    29.1%
Percentage of net sales   2.1%   0.1%             2.5%   1.8%          

 

The increase in loss available to common stockholders is primarily due to lower margins and higher interest expense for the three and nine months ended September 30, 2018 as compared to the same periods in 2017.

 

Liquidity and Capital Resources

 

During the nine months ended September 30, 2018, we funded our operations primarily from cash on hand, cash generated from our operations and advances from our revolving credit facilities. These funds were also used to make capital expenditures, capital lease payments and principal payments on term and revolving debt.

 

Our current available capital resources consist of cash on hand and amounts available for borrowing under our credit facilities. We expect that our future available capital resources will consist primarily of our remaining cash balances, cash generated from our operations, and amounts available for borrowing, if any, under our credit facilities.

 

We believe that current and future available capital resources, including cash generated from our operations, and other existing sources of liquidity, including our credit facilities, will be adequate to meet our anticipated capital requirements for at least the next twelve months.

 

Quantitative Quarter-End Liquidity Status

 

We believe that the following amounts provide insight into our liquidity and capital resources. The following selected financial information should be read in conjunction with our consolidated financial statements and notes to consolidated financial statements included elsewhere in this report, and the other sections of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in this report (dollars in thousands):

 

  

September 30, 2018

  

December 31, 2017

  

Change

 
Cash and cash equivalents  $56,093   $49,489    13.3%
Current assets  $192,266   $203,246    (5.4)%
Property and equipment, net  $488,591   $508,352    (3.9)%
Current liabilities  $99,020   $90,706    9.2%
Long-term debt, net of current portion  $214,419   $221,091    (3.0)%
Working capital  $93,246   $112,540    (17.1)%
Working capital ratio   1.94    2.24    (13.4)%

 

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Restricted Net Assets

 

At September 30, 2018, we had approximately $207.2 million of net assets at our subsidiaries that were not available to be transferred to Pacific Ethanol, Inc. in the form of dividends, loans or advances due to restrictions contained in the credit facilities of our subsidiaries.

 

Changes in Working Capital and Cash Flows

 

Working capital decreased to $93.2 million at September 30, 2018 from $112.5 million at December 31, 2017 as a result of a decrease of $11.0 million in current assets and an increase of $8.3 million in current liabilities.

 

Current assets decreased primarily due to decreases of $12.7 million in accounts receivable, $6.8 million in inventories, $1.8 million in prepaid inventory, partially offset by increases of $6.6 million in cash and cash equivalents, $2.8 million in other current assets and $1.0 million in derivative instruments. Our cash and cash equivalents increased by $6.6 million at September 30, 2018 as compared to December 31, 2017 due to $26.1 million of cash provided by our operations, partially offset by $10.9 million of cash used in our investing activities and $8.6 million of cash used in our financing activities.

 

Our current liabilities increased primarily due to increases of $4.2 million in accounts payable and accrued liabilities and $4.1 million in derivative instruments.

 

Cash provided by our Operating Activities

 

Cash provided by our operating activities declined by $8.9 million for the nine months ended September 30, 2018, as compared to the same period in 2018. We generated $26.1 million in cash from our operating activities during the period. Specific factors that contributed to the decrease in cash provided by our operating activities include:

 

a decrease related to net loss of $9.4 million;

a decrease related to accounts receivable of $13.0 million primarily due to the timing of collections;

a decrease related to prepaid expenses and other assets of $4.7 million due to changes in restricted cash collateral derivative balances; due to changes in period end positions and

a decrease related to prepaid inventory of $2.6 million due to the timing of purchases.

 

These amounts were partially offset by:

 

an increase related to inventories of $8.7 million due to the timing of sales;

an increase related to accounts payable and accrued expenses of $6.3 million due to the timing of payments;

an increase in depreciation expense of $2.1 million related to our ICP facilities; and

an increase related to higher losses on derivative instruments of $3.5 million due to changes in fair value of positions during the period.

 

Cash used in our Investing Activities

 

Cash used in our investing activities decreased by $30.4 million for the nine months ended September 30, 2018 as compared to the same period in 2017. The decrease in cash used in our investing activities is primarily due to our purchase of ICP in the 2017 period.

 

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Cash used in our Financing Activities

 

Cash used in our financing activities increased by $3.2 million for the nine months ended September 30, 2018 as compared to the same period in 2017. The increase in cash used in our financing activities is primarily due to increased net payments on term and revolving loans, including higher interest expense. For the third quarter of 2018, we focused on reducing our total debt, with $23.7 million paid in the quarter through a combination of term loan repayments and reduced usage of revolving credit facilities.

 

Kinergy Operating Line of Credit

 

Kinergy maintains an operating line of credit for an aggregate amount of up to $100.0 million. The credit facility matures on August 2, 2022. Interest accrues under the credit facility at a rate equal to (i) the three-month London Interbank Offered Rate (“LIBOR”), plus (ii) a specified applicable margin ranging from 1.50% to 2.00%. The credit facility’s monthly unused line fee is 0.25% to 0.375% of the amount by which the maximum credit under the facility exceeds the average daily principal balance during the immediately preceding month. Payments that may be made by Kinergy to Pacific Ethanol as reimbursement for management and other services provided by Pacific Ethanol to Kinergy are limited under the terms of the credit facility to $1.5 million per fiscal quarter. The credit facility also includes the accounts receivable of Pacific Ag. Products, LLC, or PAP, as additional collateral. Payments that may be made by PAP to Pacific Ethanol as reimbursement for management and other services provided by Pacific Ethanol to PAP are limited under the terms of the credit facility to $0.5 million per fiscal quarter. PAP, one of our indirect wholly-owned subsidiaries, markets our co-products and also provides raw material procurement services to our subsidiaries.

 

For all monthly periods in which excess borrowing availability falls below a specified level, Kinergy and PAP must collectively maintain a fixed-charge coverage ratio (calculated as a twelve-month rolling earnings before interest, taxes, depreciation and amortization (EBITDA) divided by the sum of interest expense, capital expenditures, principal payments of indebtedness, indebtedness from capital leases and taxes paid during such twelve-month rolling period) of at least 2.0 and are prohibited from incurring certain additional indebtedness (other than specific intercompany indebtedness). Kinergy’s and PAP’s obligations under the credit facility are secured by a first-priority security interest in all of their assets in favor of the lender. Kinergy and PAP believe they are in compliance with this covenant. The following table summarizes Kinergy’s financial covenants and actual results for the periods presented (dollars in thousands):

 

   Three Months Ended
September 30,
   Years Ended
December 31,
 
   2018   2017   2017   2016 
                 
Fixed-Charge Coverage Ratio Requirement   2.00    2.00    2.00    2.00 
Actual   18.77    3.01    2.79    7.88 
Excess   16.77    1.01    0.79    5.88 

 

For all periods presented above, Kinergy maintained more than the minimum excess borrowing availability required; accordingly, the fixed-charge coverage ratio requirement did not apply.

 

Pacific Ethanol has guaranteed all of Kinergy’s obligations under the credit facility. As of September 30, 2018, Kinergy had an outstanding balance of $59.4 million with additional borrowing availability under the credit facility of $5.2 million.

 

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Pekin Credit Facilities

 

On December 15, 2016, our wholly-owned subsidiary, Pacific Ethanol Pekin, LLC, or Pekin, entered into term and revolving credit facilities. Pekin borrowed $64.0 million under a term loan facility that matures on August 20, 2021 and $32.0 million under a revolving credit facility that matures on February 1, 2022. The Pekin credit facilities are secured by a first-priority security interest in all of Pekin’s assets. Interest initially accrued under the Pekin credit facilities at an annual rate equal to the 30-day LIBOR plus 3.75%, payable monthly. Pekin is required to make quarterly principal payments in the amount of $3.5 million on the term loan beginning on May 20, 2017, with the remaining principal balance payable at maturity on August 20, 2021. Pekin is required to pay monthly in arrears a fee on any unused portion of the revolving credit facility at a rate of 0.75% per annum. Prepayment of these facilities is subject to a prepayment penalty. Under the initial terms of the credit facilities, Pekin was required to maintain not less than $20.0 million in working capital and an annual debt service coverage ratio of not less than 1.25 to 1.0.

 

On August 7, 2017, Pekin amended its term and revolving credit facilities by agreeing to increase the interest rate under the facilities by 25 basis points to an annual rate equal to the 30-day LIBOR plus 4.00%. Pekin and its lender also agreed that Pekin is required to maintain working capital of not less than $17.5 million from August 31, 2017 through December 31, 2017 and working capital of not less than $20.0 million from January 1, 2018 and continuing at all times thereafter. In addition, the required debt service coverage ratio was reduced to 0.15 to 1.00 for the fiscal year ended December 31, 2017. Pekin’s actual debt service coverage ratio was 0.17 to 1.00 for the fiscal year ended December 31, 2017, 0.02 in excess of the required 0.15 to 1.00. For the month ended January 31, 2018, Pekin was not in compliance with its working capital requirement due to larger than anticipated repair and maintenance related expenses to replace faulty equipment. Pekin has received a waiver from its lender for this noncompliance. Further, the lender decreased Pekin’s working capital covenant requirement to $13.0 million for the month ended February 28, 2018, excluding from the calculation a $3.5 million principal payment previously due in May 2018.

 

On March 30, 2018, Pekin further amended its term loan facility by reducing the amount of working capital it is required to maintain to not less than $13.0 million from March 31, 2018 through November 30, 2018 and not less than $16.0 million from December 1, 2018 and continuing at all times thereafter. In addition, a principal payment in the amount of $3.5 million due for May 2018 was deferred until the maturity date of the term loan. As of the filing of this report, we believe Pekin is in compliance with its working capital requirement.

 

As of September 30, 2018, Pekin had additional borrowing availability under its revolving credit facility of $2.0 million.

 

ICP Credit Facilities

 

On September 15, 2017, ICP entered into term and revolving credit facilities. ICP borrowed $24.0 million under a term loan facility that matures on September 20, 2021 and $18.0 million under a revolving credit facility that matures on September 1, 2022. The ICP credit facilities are secured by a first-priority security interest in all of ICP’s assets. Interest accrues under the ICP credit facilities at an annual rate equal to the 30-day LIBOR plus 3.75%, payable monthly. ICP is required to make quarterly consecutive principal payments in the amount of $1.5 million. ICP is required to pay monthly in arrears a fee on any unused portion of the revolving credit facility at a rate of 0.75% per annum. Prepayment of these facilities is subject to a prepayment penalty. Under the terms of the credit facilities, ICP is required to maintain not less than $8.0 million in working capital and an annual debt service coverage ratio of not less than 1.5 to 1.0, beginning for the year ended December 31, 2018.

 

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As of September 30, 2018, ICP had additional borrowing availability under its revolving credit facility of $4.0 million.

 

Pacific Ethanol, Inc. Notes Payable

 

On December 12, 2016, we entered into a Note Purchase Agreement with five accredited investors. On December 15, 2016, under the terms of the Note Purchase Agreement, we sold $55.0 million in aggregate principal amount of our senior secured notes to the investors in a private offering for aggregate gross proceeds of 97% of the principal amount of the notes sold. On June 26, 2017, we entered into a second Note Purchase Agreement with five accredited investors. On June 30, 2017, under the terms of the second Note Purchase Agreement, we sold an additional $13.9 million in aggregate principal amount of our senior secured notes to the investors in a private offering for aggregate gross proceeds of 97% of the principal amount of the notes sold, for a total of $68.9 million in aggregate principal amount of senior secured notes.

 

The notes mature on December 15, 2019. Interest on the notes accrues at an annual rate equal to (i) the greater of 1% and the three-month LIBOR, plus 7.0% from the closing through December 14, 2017, (ii) the greater of 1% and three-month LIBOR, plus 9% between December 15, 2017 and December 14, 2018, and (iii) the greater of 1% and three-month LIBOR plus 11% between December 15, 2018 and the maturity date. The interest rate increases by an additional 2% per annum above the interest rate otherwise applicable upon the occurrence and during the continuance of an event of default until cured. Interest is payable in cash in arrears on the 15th calendar day of each March, June, September and December. We are required to pay all outstanding principal and any accrued and unpaid interest on the notes on the maturity date. We may, at our option, prepay the outstanding principal amount of the notes at any time without premium or penalty. Pacific Ethanol, Inc. issued the notes, which are secured by a first-priority security interest in the equity interest held by Pacific Ethanol, Inc. in its wholly-owned subsidiary, PE Op. Co., which indirectly owns our plants located on the West Coast.

 

We are actively evaluating opportunities to refinance our senior notes well in advance of their December 2019 maturity.

 

Contractual Obligations

 

There have been no material changes in the nine months ended September 30, 2018 to the amounts presented in the table under the “Contractual Obligations” section in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation” of our Annual Report on Form 10-K for 2017.

 

Effects of Inflation

 

The impact of inflation was not significant to our financial condition or results of operations for the three and nine months ended September 30, 2018 and 2017.

 

ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

Not applicable.

 

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ITEM 4.CONTROLS AND PROCEDURES.

 

Evaluation of Disclosure Controls and Procedures

 

We conducted an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures also include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded as of September 30, 2018 that our disclosure controls and procedures were effective at a reasonable assurance level.

 

Changes in Internal Control over Financial Reporting

 

There has been no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

Inherent Limitations on the Effectiveness of Controls

 

Management does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control systems are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in a cost-effective control system, no evaluation of internal control over financial reporting can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, have been or will be detected.

 

These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of a simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

 

PART II - OTHER INFORMATION

 

ITEM 1.LEGAL PROCEEDINGS.

 

We are subject to legal proceedings, claims and litigation arising in the ordinary course of business. While the amounts claimed may be substantial, the ultimate liability cannot presently be determined because of considerable uncertainties that exist. Therefore, it is possible that the outcome of those legal proceedings, claims and litigation could adversely affect our quarterly or annual operating results or cash flows when resolved in a future period. However, based on facts currently available, management believes such matters will not adversely affect in any material respect our financial position, results of operations or cash flows.

 

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People of the State of Illinois v. Pacific Ethanol Pekin, LLC, case no. 18-CH-06, was filed on January 8, 2018 in the Circuit Court for the 10th Judicial Circuit in Tazewell County, Illinois. The Illinois Attorney General, on behalf of the People of the State of Illinois, alleges violations of the Pekin facility’s NPDES permit and water pollution associated with the facility’s discharge. Most of the alleged violations relate to thermal limits set forth in the permit. The complaint seeks a cease and desist order and damages for the alleged violations in accordance with statutory limits under the Illinois Environmental Protection Act. We are currently in negotiations with the Illinois Attorney General seeking to resolve this matter. The parties have agreed upon the language of an Agreed Interim Order that will allow the Pekin facility to continue operating in accordance with agreed-upon thermal limits while the state considers our application for a permit amendment incorporating the results of a mixing study into the facility’s permit.

 

ITEM 1A.RISK FACTORS.

 

Before deciding to purchase, hold or sell our common stock, you should carefully consider the risks described below in addition to the other information contained in this Report and in our other filings with the Securities and Exchange Commission, including subsequent reports on Forms 10-Q and 8-K. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks or uncertainties actually occurs with material adverse effects on Pacific Ethanol, our business, financial condition, results of operations and/or liquidity could be seriously harmed. In that event, the market price for our common stock will likely decline, and you may lose all or part of your investment.

 

Risks Related to our Business

 

We have incurred significant losses and negative operating cash flow in the past and we may incur losses and negative operating cash flow in the future, which may hamper our operations and impede us from expanding our business.

 

We have incurred significant losses and negative operating cash flow in the past. For the three months ended September 30, 2018 and 2017, we incurred consolidated net losses of approximately $9.3 million and $0.5 million, respectively. For the nine months ended September 30, 2018 and 2017, we incurred consolidated net losses of approximately $33.4 million and $24.0 million, respectively. For the years ended December 31, 2017 and 2015, we incurred consolidated net losses of approximately $38.1 million and $18.9 million, respectively. For the year ended December 31, 2015, we incurred negative operating cash flows of $28.0 million. We may incur losses and negative operating cash flow in the future. We expect to rely on cash on hand, cash, if any, generated from our operations, borrowing availability under our lines of credit and proceeds from future financing activities, if any, to fund all of the cash requirements of our business. Continued losses and negative operating cash flow may hamper our operations and impede us from expanding our business.

 

Our results of operations and our ability to operate at a profit is largely dependent on managing the costs of corn and natural gas and the prices of ethanol, distillers grains and other ethanol co-products, all of which are subject to significant volatility and uncertainty.

 

Our results of operations are highly impacted by commodity prices, including the cost of corn and natural gas that we must purchase, and the prices of ethanol, distillers grains and other ethanol co-products that we sell. Prices and supplies are subject to and determined by market and other forces over which we have no control, such as weather, domestic and global demand, supply shortages, export prices and various governmental policies in the United States and around the world.

 

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As a result of price volatility of corn, natural gas, ethanol, distillers grains and other ethanol co-products, our results of operations may fluctuate substantially. In addition, increases in corn or natural gas prices or decreases in ethanol, distillers grains or other ethanol co-product prices may make it unprofitable to operate. In fact, some of our marketing activities will likely be unprofitable in a market of generally declining ethanol prices due to the nature of our business. For example, to satisfy customer demands, we maintain certain quantities of ethanol inventory for subsequent resale. Moreover, we procure much of our inventory outside the context of a marketing arrangement and therefore must buy ethanol at a price established at the time of purchase and sell ethanol at an index price established later at the time of sale that is generally reflective of movements in the market price of ethanol. As a result, our margins for ethanol sold in these transactions generally decline and may turn negative as the market price of ethanol declines.

 

No assurance can be given that corn or natural gas can be purchased at, or near, current or any particular prices or that ethanol, distillers grains or other ethanol co-products will sell at, or near, current or any particular prices. Consequently, our results of operations and financial position may be adversely affected by increases in the price of corn or natural gas or decreases in the price of ethanol, distillers grains or other ethanol co-products.

 

Over the past several years, the spread between ethanol and corn prices has fluctuated significantly. Fluctuations are likely to continue to occur. A sustained narrow spread, whether as a result of sustained high or increased corn prices or sustained low or decreased ethanol prices, would adversely affect our results of operations and financial position. Further, combined revenues from sales of ethanol, distillers grains and other ethanol co-products could decline below the marginal cost of production, which may force us to suspend production of ethanol, distillers grains and other ethanol co-products at some or all of our plants.

 

Increased ethanol production or higher inventory levels may cause a decline in ethanol prices or prevent ethanol prices from rising, and may have other negative effects, adversely impacting our results of operations, cash flows and financial condition.

 

We believe that the most significant factor influencing the price of ethanol has been the substantial increase in ethanol production. According to the Renewable Fuels Association, domestic ethanol production capacity increased from an annualized rate of 1.5 billion gallons per year in January 1999 to a record 16.2 billion gallons in 2017. In addition, if ethanol production margins improve, we anticipate that owners of ethanol production facilities will increase production levels, thereby resulting in more abundant ethanol supplies and inventories. Any increase in the supply of ethanol may not be commensurate with increases in the demand for ethanol, thus leading to lower ethanol prices. Also, demand for ethanol could be impaired due to a number of factors, including regulatory developments and reduced United States gasoline consumption. Reduced gasoline consumption has occurred in the past and could occur in the future as a result of increased gasoline or oil prices or other factors such as increased automobile fuel efficiency. Any of these outcomes could have a material adverse effect on our results of operations, cash flows and financial condition.

 

The market price of ethanol is volatile and subject to large fluctuations, which may cause our profitability or losses to fluctuate significantly.

 

The market price of ethanol is volatile and subject to large fluctuations. The market price of ethanol is dependent upon many factors, including the supply of ethanol and the price of gasoline, which is in turn dependent upon the price of petroleum which is highly volatile and difficult to forecast. For example, ethanol prices, as reported by the CBOT, ranged from $1.26 to $1.67 per gallon during 2017 and $1.31 to $1.75 per gallon during 2016. Fluctuations in the market price of ethanol may cause our profitability or losses to fluctuate significantly.

 

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Some of our marketing activities will likely be unprofitable in a market of generally declining ethanol prices due to the nature of our business.

 

Some of our marketing activities will likely be unprofitable in a market of generally declining ethanol prices due to the nature of our business. For example, to satisfy customer demands, we maintain certain quantities of ethanol inventory for subsequent resale. Moreover, we procure much of our inventory outside the context of a marketing arrangement and therefore must buy ethanol at a price established at the time of purchase and sell ethanol at an index price established later at the time of sale that is generally reflective of movements in the market price of ethanol. As a result, our margins for ethanol sold in these transactions generally decline and may turn negative as the market price of ethanol declines.

 

Disruptions in production or distribution infrastructure may adversely affect our business, results of operations and financial condition.

 

Our business depends on the continuing availability of rail, road, port, storage and distribution infrastructure. In particular, due to limited storage capacity at our plants and other considerations related to production efficiencies, our plants depend on just-in-time delivery of corn. The production of ethanol and specialty alcohols also requires a significant and uninterrupted supply of other raw materials and energy, primarily water, electricity and natural gas. Local water, electricity and gas utilities may not be able to reliably supply the water, electricity and natural gas that our plants need or may not be able to supply those resources on acceptable terms. During 2014, poor weather caused disruptions in rail transportation, which slowed the delivery of ethanol by rail, the principle manner by which ethanol from our plants located in the Midwest is transported to market. Disruptions in production or distribution infrastructure, whether caused by labor difficulties, earthquakes, storms, other natural disasters or human error or malfeasance or other reasons, could prevent timely deliveries of corn or other raw materials and energy, and could delay transport of our products to market, and may require us to halt production at one or more plants, any of which could have a material adverse effect on our business, results of operations and financial condition.

 

We may engage in hedging transactions and other risk mitigation strategies that could harm our results of operations and financial condition.

 

In an attempt to partially offset the effects of volatility of ethanol prices and corn and natural gas costs, we may enter into contracts to fix the price of a portion of our ethanol production or purchase a portion of our corn or natural gas requirements on a forward basis. In addition, we may engage in other hedging transactions involving exchange-traded futures contracts for corn, natural gas and unleaded gasoline from time to time. The financial statement impact of these activities is dependent upon, among other things, the prices involved and our ability to sell sufficient products to use all of the corn and natural gas for which forward commitments have been made. Hedging arrangements also expose us to the risk of financial loss in situations where the other party to the hedging contract defaults on its contract or, in the case of exchange-traded contracts, where there is a change in the expected differential between the underlying price in the hedging agreement and the actual prices paid or received by us. In addition, our open contract positions may require cash deposits to cover margin calls, negatively impacting our liquidity. As a result, our results of operations and financial condition may be adversely affected by our hedging activities and fluctuations in the price of corn, natural gas, ethanol and unleaded gasoline.

 

Operational difficulties at our plants could negatively impact sales volumes and could cause us to incur substantial losses.

 

Operations at our plants are subject to labor disruptions, unscheduled downtimes and other operational hazards inherent in the ethanol production industry, including equipment failures, fires, explosions, abnormal pressures, blowouts, pipeline ruptures, transportation accidents and natural disasters. Some of these operational hazards may cause personal injury or loss of life, severe damage to or destruction of property and equipment or environmental damage, and may result in suspension of operations and the imposition of civil or criminal penalties. Our insurance may not be adequate to fully cover the potential operational hazards described above or we may not be able to renew this insurance on commercially reasonable terms or at all.

 

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Moreover, our plants may not operate as planned or expected. All of these facilities are designed to operate at or above a specified production capacity. The operation of these facilities is and will be, however, subject to various uncertainties. As a result, these facilities may not produce ethanol, specialty alcohols and co-products at expected levels. In the event any of these facilities do not run at their expected capacity levels, our business, results of operations and financial condition may be materially and adversely affected.

 

Future demand for ethanol is uncertain and may be affected by changes to federal mandates, public perception, consumer acceptance and overall consumer demand for transportation fuel, any of which could negatively affect demand for ethanol and our results of operations.

 

Although many trade groups, academics and governmental agencies have supported ethanol as a fuel additive that promotes a cleaner environment, others have criticized ethanol production as consuming considerably more energy and emitting more greenhouse gases than other biofuels and potentially depleting water resources. Some studies have suggested that corn-based ethanol is less efficient than ethanol produced from other feedstock and that it negatively impacts consumers by causing increased prices for dairy, meat and other food generated from livestock that consume corn. Additionally, ethanol critics contend that corn supplies are redirected from international food markets to domestic fuel markets. If negative views of corn-based ethanol production gain acceptance, support for existing measures promoting use and domestic production of corn-based ethanol could decline, leading to reduction or repeal of federal mandates, which could adversely affect the demand for ethanol. These views could also negatively impact public perception of the ethanol industry and acceptance of ethanol as an alternative fuel.

 

There are limited markets for ethanol beyond those established by federal mandates. Discretionary blending and E85 blending are important secondary markets. Discretionary blending is often determined by the price of ethanol versus the price of gasoline. In periods when discretionary blending is financially unattractive, the demand for ethanol may be reduced. Also, the demand for ethanol is affected by the overall demand for transportation fuel. Demand for transportation fuel is affected by the number of miles traveled by consumers and the fuel economy of vehicles. Market acceptance of E15 may partially offset the effects of decreases in transportation fuel demand. A reduction in the demand for ethanol and ethanol co-products may depress the value of our products, erode our margins and reduce our ability to generate revenue or to operate profitably. Consumer acceptance of E15 and E85 fuels is needed before ethanol can achieve any significant growth in market share relative to other transportation fuels.

 

Our future results will suffer if we do not effectively manage our expanded operations.

 

Our business following recent acquisitions is larger than the individual businesses of Pacific Ethanol and the acquired companies prior to the acquisitions. Our future success depends, in part, upon our ability to manage our expanded business, which may pose continued challenges for our management, including challenges related to the management and monitoring of new operations and associated increased costs and complexity. We cannot assure you that we will be successful or that we will realize the expected operating efficiencies, annual net operating synergies, revenue enhancements and other benefits currently anticipated to result from the acquisition.

 

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Our plant indebtedness exposes us to many risks that could negatively impact our business, our business prospects, our liquidity and our cash flows and results of operations.

 

Our plants located in the Midwest have significant indebtedness. Unlike traditional term debt, the terms of our plant loans require amortizing payments of principal over the lives of the loans and our borrowing availability under our plant credit facilities periodically and automatically declines through the maturity dates of those facilities. Our plant indebtedness could:

 

make it more difficult to pay or refinance our debts as they become due during adverse economic and industry conditions because any decrease in revenues could cause us to not have sufficient cash flows from operations to make our scheduled debt payments;

 

limit our flexibility to pursue strategic opportunities or react to changes in our business and the industry in which we operate and, consequently, place us at a competitive disadvantage to our competitors who have less debt;

 

require a substantial portion of our cash flows from operations to be used for debt service payments, thereby reducing the availability of our cash flows to fund working capital, capital expenditures, acquisitions, dividend payments and other general corporate purposes; and/or

 

limit our ability to procure additional financing for working capital or other purposes.

 

Our term loans and credit facilities also require compliance with numerous financial and other covenants. In addition, our plant indebtedness bears interest at variable rates. An increase in prevailing interest rates would likewise increase our debt service obligations and could materially and adversely affect our cash flows and results of operations.

 

Our ability to generate sufficient cash to make all principal and interest payments when due depends on our business performance, which is subject to a variety of factors beyond our control, including the supply of and demand for ethanol and co-products, ethanol and co-product prices, the cost of key production inputs, and many other factors incident to the ethanol production and marketing industry. We cannot provide any assurance that we will be able to timely satisfy such obligations. Our failure to timely satisfy our debt obligations could have a material adverse effect on our business, business prospects, liquidity, cash flows and results of operations.

 

If Kinergy fails to satisfy its financial covenants under its credit facility, it may experience a loss or reduction of that facility, which would have a material adverse effect on our financial condition and results of operations.

 

We are substantially dependent on Kinergy’s credit facility to help finance its operations. Kinergy must satisfy monthly financial covenants under its credit facility, including fixed-charge coverage ratio covenants. Kinergy will be in default under its credit facility if it fails to satisfy any financial covenant. A default may result in the loss or reduction of the credit facility. The loss of Kinergy’s credit facility, or a significant reduction in Kinergy’s borrowing capacity under the facility, would result in Kinergy’s inability to finance a significant portion of its business and would have a material adverse effect on our financial condition and results of operations.

 

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The United States ethanol industry is highly dependent upon certain federal and state legislation and regulation and any changes in legislation or regulation could have a material adverse effect on our results of operations, cash flows and financial condition.

 

The EPA has implemented the RFS pursuant to the Energy Policy Act of 2005 and the Energy Independence and Security Act of 2007. The RFS program sets annual quotas for the quantity of renewable fuels (such as ethanol) that must be blended into motor fuels consumed in the United States. The domestic market for ethanol is significantly impacted by federal mandates under the RFS program for volumes of renewable fuels (such as ethanol) required to be blended with gasoline. Future demand for ethanol will be largely dependent upon incentives to blend ethanol into motor fuels, including the price of ethanol relative to the price of gasoline, the relative octane value of ethanol, constraints in the ability of vehicles to use higher ethanol blends, the RFS, and other applicable environmental requirements. Any significant increase in production capacity above the RFS minimum requirements may have an adverse impact on ethanol prices.

 

Legislation aimed at reducing or eliminating the renewable fuel use required by the RFS has been introduced in the United States Congress. On January 3, 2017, the Leave Ethanol Volumes at Existing Levels (LEVEL) Act (H.R. 119) was introduced in the House of Representatives. The bill would freeze renewable fuel blending requirements under the RFS at 7.5 billion gallons per year, prohibit the sale of gasoline containing more than 10% ethanol, and revoke the EPA’s approval of E15 blends. On January 31, 2017, a bill (H.R. 777) was introduced in the House of Representatives that would require the EPA and National Academies of Sciences to conduct a study on “the implications of the use of mid-level ethanol blends”. A mid-level ethanol blend is an ethanol-gasoline blend containing 10-20% ethanol by volume, including E15 and E20, which is intended to be used in any conventional gasoline-powered motor vehicle or nonroad vehicle or engine. Also on January 31, 2017, a bill (H.R. 776) was introduced in the House of Representatives that would limit the volume of cellulosic biofuel required under the RFS to what is commercially available. On March 2, 2017, a bill (H.R. 1315) was introduced in the House of Representatives that would cap the volume of ethanol in gasoline at 10%. On the same day, the RFS Elimination Act (H.R. 1314) was introduced, which would fully repeal the RFS. On March 8, 2018, the Growing Renewable Energy through Existing and New Environmentally Responsible (GREENER) Fuels Act (H.R. 5212 and S. 2519) was introduced in the House of Representatives and Senate. The GREENER Fuels Act would phase-out the mandated use of corn ethanol and limit the total volume of conventional biofuel contained in transportation fuel at 9.7%.

 

All of these bills were referred to a congressional committee or subcommittee, which will consider them before possibly sending any of them on to the House of Representatives as a whole. Our operations could be adversely impacted if any legislation is enacted that reduces or eliminates the RFS volume requirements or that reduces or eliminates corn ethanol as qualifying as a renewable fuel under the RFS.

 

Under the provisions of the Clean Air Act, as amended by the Energy Independence and Security Act of 2007, the EPA has limited authority to waive or reduce the mandated RFS requirements, which authority is subject to consultation with the Secretaries of Agriculture and Energy, and based on a determination that there is inadequate domestic renewable fuel supply or implementation of the applicable requirements would severely harm the economy or environment of a state, region or the United States. Our results of operations, cash flows and financial condition could be adversely impacted if the EPA reduces the RFS requirements from the statutory levels specified in the RFS.

 

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The ethanol production and marketing industry is extremely competitive. Many of our significant competitors have greater production and financial resources and one or more of these competitors could use their greater resources to gain market share at our expense.

 

The ethanol production and marketing industry is extremely competitive. Many of our significant competitors in the ethanol production and marketing industry, including Archer-Daniels-Midland Company, POET, LLC, Green Plains, Inc. and Valero Renewable Fuels Company, LLC, have substantially greater production and/or financial resources. As a result, our competitors may be able to compete more aggressively and sustain that competition over a longer period of time. Successful competition will require a continued high level of investment in marketing and customer service and support. Our limited resources relative to many significant competitors may cause us to fail to anticipate or respond adequately to new developments and other competitive pressures. This failure could reduce our competitiveness and cause a decline in market share, sales and profitability. Even if sufficient funds are available, we may not be able to make the modifications and improvements necessary to compete successfully.

 

We also face competition from international suppliers. Currently, international suppliers produce ethanol primarily from sugar cane and have cost structures that are generally substantially lower than our cost structures. Any increase in domestic or foreign competition could cause us to reduce our prices and take other steps to compete effectively, which could adversely affect our business, financial condition and results of operations.

 

Our ability to utilize net operating loss carryforwards and certain other tax attributes may be limited.

 

Federal and state income tax laws impose restrictions on the utilization of net operating loss, or NOL, and tax credit carryforwards in the event that an “ownership change” occurs for tax purposes, as defined by Section 382 of the Internal Revenue Code, or Code. In general, an ownership change occurs when stockholders owning 5% or more of a “loss corporation” (a corporation entitled to use NOL or other loss carryovers) have increased their ownership of stock in such corporation by more than 50 percentage points during any three-year period. The annual base limitation under Section 382 of the Code is calculated by multiplying the loss corporation’s value at the time of the ownership change by the greater of the long-term tax-exempt rate determined by the Internal Revenue Service in the month of the ownership change or the two preceding months.

 

As of December 31, 2017, of our $154.6 million of federal NOLs, we had $94.9 million of federal NOLs that are limited in their annual use under Section 382 of the Code. Accordingly, our ability to utilize these NOL carryforwards may be substantially limited. These limitations could in turn result in increased future tax obligations, which could have a material adverse effect on our business, financial condition and results of operations.

 

Our business is not diversified. The high concentration of our sales within the ethanol production and marketing industry could result in a significant reduction in sales and negatively affect our profitability if demand for ethanol declines.

 

Our business is not diversified. Our sales are highly concentrated within the ethanol production and marketing industry. We expect to be substantially focused on the production and marketing of ethanol and its co-products for the foreseeable future. An industry shift away from ethanol, or the emergence of new competing products, may significantly reduce the demand for ethanol. However, we may be unable to timely alter our business focus away from the production and marketing of ethanol to other renewable fuels or competing products. A downturn in the demand for ethanol would likely materially and adversely affect our sales and profitability.