Is This European Energy Giant Flashing a Buy Signal in the U.S. Wood Pellet Market?

 

June 12, 2014

 

When you think of burning wood, you probably imagine a campfire or a decorative fireplace. You most likely don't think about using wood to actually heat a home or generate electricity. However, that's increasingly exactly what's happening. You can get an inside seat in this growing business with an investment in Rentech (NASDAQ: RTK  ) or Europe's Drax Group (NASDAQOTH: DRXGY  ) .

 

Getting big on wood

According to the Energy Information Administration (EIA), wood pellet exports nearly doubled last year, going from 1.8 million tons to 3.2 million tons. The vast majority of these exports are headed to our European neighbors. The United Kingdom alone accounted for nearly 60% of these exports. The cost of transportation is a big issue with wood pellets, so the United States' location versus suppliers from South America and western Canada provides a competitive advantage.

 

 

Source: EIA

 

Another nice thing about wood pellets is that they are made from both fresh cut trees and the scraps from processing wood for other purposes (paper, lumber, etc). In addition to wood being biodegradable and environmentally friendly (assuming that sustainable forestry is being employed), wood pellets also allow us to get more out of the wood we use for other things.

 

Europe's Drax is a big proponent of this fuel source. Spurred by European environmental regulations, Drax is in the process of converting three coal plants to burn wood pellets. In fact, during the company's first quarter conference call, CEO Dorothy Thompson stated, "the increasing cost of carbon drove earnings down year on year. Recognizing this, we have been investing significant capital to transform Drax into one of the world's largest renewable generators, burning sustainable biomass."

 

That means burning more wood, and it creates a key customer for the U.S. market to serve. According to Drax's Thompson, the company is getting "good output, efficiency and reliability from our first converted unit." Drax is putting its money where its mouth is, too, building wood pellet plants in the United States. It will need them, since it hopes to have all three of its coal plants converted to biomass by 2016.

 

Although switching to wood has increased some regulated emissions, that's likely a solvable problem in the long run. The bigger benefit is that Drax will meet environmental regulations. Once the conversion spending is complete and Drax has gotten a better handle on using biomass, it should be able to lift its operating margin from the dismal low single-digit level achieved in 2013.

 

The U.S. opportunity

European demand is part of the reason why Rentech is getting into the wood business. Right now, Rentech is largely the general partner for a fertilizer limited partnership. However, it is quickly building a wood business (about one third of revenues in the first quarter). The wood side of Rentech is predominantly a fibers operation today, but the company recently inked a deal to buy a wood pellet business.

 

That investment was backed by a $150 million investment in Rentech by asset management giant Blackstone Group (NYSE: BX  ) . For the cash, Blackstone gets two seats on Rentech's board. The wood pellet business Rentech is buying has a 15% share of the domestic wood pellet heating market, but the real opportunity could be supplying Europe's increasing demand.

 

 

(Source: D-Kuru, via Wikimedia Commons)

What about the U.S. market?

For now, Europe looks like a huge bright spot for Rentech and wood pellets in general. However, some industry watchers are suggesting that the U.S. should follow Europe's lead on this one and burn more wood—like Drax.

 

Although that doesn't look like it's in the cards today, the government's new regulations may lead to a shift in mindset on this front. While Drax's wood pellet facilities are meant for its own use, Rentech would certainly benefit from U.S. utilities burning more wood. That said, Rentech is most suitable for aggressive investors—particularly since this is a new business to the company. However, the plan is to eventually spin the wood business off as a limited partnership, which would provide you a pure-play wood option.