Hedging Input Price Risk for Biomass Power Plant and Pellet

Export Projects

William Strauss, PhD, President, FutureMetrics

Eric Kingsley, Principal, Innovative Natural Resource Solutions (INRS)

November 10, 2011

• Overview of the Space • Background on Pellet Exports • Key Drivers to the Pellet

Manufacturing Business Model • Hedging Wood Prices

What is the Need?

Who cares about wood prices for power and pellets? Biomass fueled power plants currently use about 30 million tons per year of wood as fuel. Another 10 million tons of capacity is under credible development. Domestic pellet manufacturer currently use about 5 million tons per year of wood. But that market is expected to increase rapidly over the next decade. Some estimates are that 80 million tons per year of North American wood will be made into utility grade pellets for export*. This presentation will focus on the pellet export sector but the techniques are just as valuable and useful for the biomass power industry. *All pellets sent to Europe have to be derived from certified sustainable forests. See www.FutureMetrics.com for research papers on the sustainability of the wood-to-energy sector,

What is a Pellet?

Wood pellets are highly densified wood (both volume and energy content) in a uniform shape.

Their use is common in Europe where hundreds

of thousands of homes have home heating systems fuel with wood pellets.

One of the fastest growing renewable energy sectors in the United States is the utility grade wood pellet export market. Global consumption of wood pellets is expected to increase from the current 15 million tons per year to 27.5 million tons per year by 2015 and to 45 million tons per year by 2020.*

*From Poyry, “Pellets - Becoming a Global Commodity? - Perspectives on the global pellet market to 2020”, April, 2011.

Why Pellet Exports?

Unlike the US, European nations have energy policies that motivate efficiency and development of alternative energy.

US Energy Policy?

What are the key input drivers of ROI for a Biomass Energy Project?

Wood Prices!

Wood Prices!!

Wood Prices!!!

[output prices are key also for selling heat, energy, and/or pellets]

Let’s look at a synergistic Combined Heat and Power plant and Pellet Plant model.

The CHP will provide all of the heat to run belt dryers and some of the electricity for the pellet factory. This is the default design in Europe and is also the design of an actual large pellet export project that FutureMetrics has developed. So this analysis is based on a CHP and pellet project making 300,000 tpy for export.

The first question should be: Is there enough wood? This project is for a 300,000 ton per year (nameplate) utility grade pellet facility with 100% of the pellets exported. If there is enough wood, then how much will it cost. The wood study should identify the significant tonnage cohorts by costs. In other words, you should have a marginal cost curve to accurately estimate wood costs.

The median prices of both residual biomass for the CHP facility and for whole tree chips for the pellet plant can be estimated.

Wood Price Heat Price (MMBTU)

$15 $7.68

$16 $7.90$17 $8.12

$18 $8.34

$19 $8.57

$20 $8.79$21 $9.01$22 $9.24$23 $9.46$24 $9.68$25 $9.90

$26 $10.13$27 $10.35

$28 $10.57$29 $10.79$30 $11.02

The residual (low grade) wood price matters! The cost per million BTU/hr (or MW) that the dryer has to pay the CHP is determined by the wood price. (Note that in this model the electricity into the pellet plant from the CHP plant is pegged at $0.10/kWh)

The heat needed to dry enough wood for 300,000 tons per year (35 tons per hour) of pellets is about 33MW or 110 MMBTU/hr*. The wood demand for the CHP plant is about 200,000 tons per year. The pellet plant will demand about 500,000 tons per year of green chips and will also receive about 35,000 tons per year of dry sawdust.

*This average demand is based on Maine monthly median temperatures and humidity's.

Equipment RequirementsTruck ScalesTruck DumperRaw Material Infeed Station and SiloRaw Material Transfer ConveyorSuspended MagnetDryer Infeed and Discharge ConveyorsBelt DryersDryer Fuel Storage Silo, Unloader, and Discharge ConveyorDryer Burner Fuel Conveying System (pneumatic)Dryer Burner 45 million BTU/hr (wood fueled with controls and feed system)Chip ScreenersScreener Output (Acceptable and Oversized) ConveyorsHammer Mills (course input and processed chips mills)Pneumatic System (Hammer Mill Take-Aways pre-dryer and post dryer)Dry Material Silos, Unloaders, and Conveyors (dust and dryed chips)Pellet Mill Surge HoppersPellet Mills, Conditioners and MotorsStart-up Dies for Pellet MillsSpare Rollers and Shells for Pellet MillPellet Mill Discharge Conveying SystemPellet CoolerCooler Air System and FiltersScreener for Removing FinesFines Conveying SystemFinished Pellets Screener Discharge Conveyor and Bucket ElevatorOn Site Pellet Storage SilosPellet Storage Discharge Conveyor and Fines ScreenerBagging System (Hopper, Scale, Fill and Seal Bagger, Stacker, Wrapper)Structural Steel (not including buildings)Electrical Service, Controls, and Control SystemsEngineering (includes permitting)Boiler & Hardware (Office and Maintenance Area Heat)Miscellaneous Spare Parts

Process Equipment BudgetOther Costs

Front End LoadersFork LiftLandBuildings (Process and Warehouse - Includes all site prep work and erection)Site & Driveway WorkFire Protection and Spark Detection SystemsStart-up Bags, Slip-Covers & PalletsOther Start-up Costs (including payroll and vendor oversight) & Working CapitalFreightMarketing & Administrative Costs

Total Other CostsContracting and Construction Costs (mechanical and electrical other than buildings)

Debt Contingency for Construction Period and StartupTotal Debt

Total Equity InvestmentTotal Capital Cost

Some of the inputs to the capital cost model for the pellet factory.

Wood Chip Cost (avg delivered)Sawdust Cost (green and kiln dried avg delivered)CHP fuel cost (avg delievered)Ratio of Chips to SawdustConversion Rate from Chips and Green Sawdust to PelletsConversion Rate from Kiln Dried Sawdust to PelletsTons per hour of Chips ProducedElectricity CostOperator and Maintenance Labor + BenefitsLoader and Fork Truck Driver Labor + BenefitsOffice Staff + BenefitsPlant ManagerMaterial Supply ManagerSales ManagerDelivery Costs to BuyersAverage Delivery Distance per ton Delivered

Kilowatts/HP

Moisture Content of Raw Material

BTU per Ton of Dry Chips and/or SawdustSteam per hour to run dryersPrice of steam to the dryersSales Price of Pellets Delivered (current price)

Other Electricity Usage

Die Capacity

Die CostRoller Shell Capacity

Roller Shell Cost (3 shells per set)Roller Bearing Capacity

Roller Bearing Cost (three rollers)

Other Parts and Maintenance Cost

Bag CostShrink Wrap CostPallet CostOn-Site Fuel Usage (loaders and fork trucks)On-Site Fuel CostTax Rate

Cost of BorrowingWorking Capital

Useful Life of EquipmentTerm of DebtAverage Annual Inflation Rate (cost of goods and parts, and wages)Fuel (pellet) Price annual escalator above baselineAnnual Plant Production (except first year)

Some of the inputs to the operating cash flow model for the pellet factory.

Horsepower Needed ==> Annual Pellet OutputRaw Material FeedersTransfer ConveyorsHammer Mills

Live Bottom/Mixing Surge BinPellet MillsConditionersCounter-flow Coolers

Air System CoolersDrag ConveyorsBucket ElevatorsScreenerBagger ConveyorDryer (roller, and fans)

Total HorsepowerTotal Connected HP Electricity Demand

Note that the pellet sales price is known and fixed with a long term contract with the European utility (more on that in a minute).

Key Output Metrics (derived from a comprehensive cash flow model)

But these are EXPECTED values. What is the RISK of a bad outcome?

ROI for total CAPEX (20 Yrs.) 23.06%

NPV (@12%, 20 Yrs.) $33,581,196.76

ROI to Equity (5 Yrs.) 50.15% (annualized)

We use @RISK to estimate the actual probability distribution for wood prices in northern Maine. It is a Beta General distribution.

We then use @RISK to estimate the probability of our project having a negative NPV (at 12%).

The likelihood is 9.0%

Looking at the sensitivity of the model to wood prices we see that the price of the wood into the pellet mill is critical. The standard deviation of the pellet mill wood cost input is $8.80. The tornado chart shows that for each $8.80 (1 std dev) increase of those wood prices, all other inputs held constant, the NPV is lowered by $22.96 million. Since the expected NPV is $35.7 million, the project is exposed to price risk.

This is further illustrated by the potential variance of wood cost as a proportion of the total cost of manufacturing pellets.

Can a project hedge their input wood prices?

Suppose that a wood aggregator is selling wood into a pellet export project. The export project has a fixed price deal with the European utility pellet buyer (with basic inflation protection and perhaps a fossil fuel escalator). The pellet manufacturer/exporter wants to insulate themselves from price risk and wants a relatively stable wood input price since they are selling at a short term fixed price. The aggregator buys from a number of wood suppliers at fluctuating market prices. Suppose the deal is to sell into the project for $35/ton but the average price from the wood suppliers for the month is $40/ton. The aggregator will lose $5/ton unless there is a way to hedge.

Wood prices going in

Hedging Strategy

Wood prices to Project

What if you could do this?

You can (almost)…

Aggregator

The FutureMetrics/INRS Wood Price Hedging Derivative

The parameters of the econometric model are all commodities with robust options and futures markets. The R2 = 0.9299.

The parameter estimates provide guidance to a weighted portfolio of futures and/or options that construct the Wood Price Hedging derivative.

The previous 12 months’ history for the model’s parameters yield probability distributions and trends that suggest that the next 36 months will have a modest rise in the price of whole tree chips for the pellet factory..

But there is also the possibility that prices will be higher.

In this example, we show a 3 year fixed hedge. Typically the period is shorter so that the risk premiums on the options and futures are lower.

At the end of each month, the derivative returns the difference. In this case in the first month the actual price is $0.80 greater than the hedged price. If the wood aggregator has a contract to deliver 60,000 tons in July at $36.90/ton but has to buy the wood at $37.70/ton, they would lose $36,300 on a gross of $1,885,000 (a 2.6% one month missed revenue).

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BIOMASSPRICE Residuals

But the derivative returns approximately the difference (recall that 93% of the price fluctuations in wood prices are captured by the model). But also note that the sum of the residuals in the model tends toward zero over time.

The aggregator has a 89.5% chance of loosing money without the hedge if the actual price follows our assumed path and the uncertainty of the price variation is based on the parameters estimated by the Price Hedging Model.

With the Hedge, the mean loss for 3 years is $18,306 (recall that the model’s residual tend to zero). Contrast that to the previous slide where the estimated loss over 3 years is $143.9 million.

Of course there will be fees associated with the product. Assuming a modest per ton fee, the expected loss is still only about 2% of the expected un-hedged loss. Note that with the fees, the probably of a “cost” is 100% but the chance of a massive “cost” is greatly reduced.

Conclusion The critical driver of biomass power or pellet projects is the price of wood. Using @RISK, we have seen this clearly for a pellet plant that will have to buy 500,000 tons per year of wood to export 300,000 tons per year of pellets. FutureMetrics and Innovative Natural Resource Solutions have developed a product that can significantly reduce price risk for these types of projects.

Using @RISK we have shown the outcome of a price scenario in which the actual prices were generally above the contracted price. The aggregator is strongly insulated from the downside pain. The product is somewhat asymmetrical. That is, if the actual price is significantly below the contracted price, the aggregator gets to participate in the upside pleasure.

Thank you William Strauss, FutureMetrics

Eric Kingsley, Innovative Natural Resource Solutions

www.FutureMetrics.com www.inrsllc.com