UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)

x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2008

OR

¨
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

PACIFIC ETHANOL, INC.
(Exact name of registrant as specified in its charter)

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

400 Capitol Mall, Suite 2060, Sacramento, California
95814
(Address of principal executive offices)
(Zip Code)

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

Securities registered pursuant to Section 12(b) of the Act: Common Stock, $0.001 par value
 
Securities registered pursuant to Section 12(g) of the Act: None
(Title of class)


Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes  ¨    No  x

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  x    No  ¨

Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

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

Large accelerated filer  ¨
Accelerated filer  x
Non-accelerated filer  ¨ (Do not check if a smaller reporting company)
Smaller reporting company  ¨

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

The aggregate market value of the voting common equity held by nonaffiliates of the registrant computed by reference to the closing sale price of such stock, was approximately $95.9 million as of June 29, 2008, the last business day of the registrant’s most recently completed second fiscal quarter. The registrant has no non-voting common equity.

The number of shares of the registrant’s common stock, $0.001 par value, outstanding as of March 26, 2009 was 57,750,319.
 
DOCUMENTS INCORPORATED BY REFERENCE:

Part III incorporates by reference certain information from the registrant’s proxy statement (the “Proxy Statement”) for the 2009 Annual Meeting of Stockholders to be filed on or before April 30, 2009.
 


 
TABLE OF CONTENTS
 
 
Page
PART I
 
Item 1.
Business
1
Item 1A.
Risk Factors.
13
Item 1B.
Unresolved Staff Comments.
24
Item 2.
Properties.
24
Item 3.
Legal Proceedings.
24
Item 4.
Submission of Matters to a Vote of Security Holders.
26
     
PART II
     
Item 5.
Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
27
Item 6.
Selected Financial Data.
30
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
31
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk.
51
Item 8.
Financial Statements and Supplementary Data.
53
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
53
Item 9A.
Controls and Procedures
53
Item 9A(T)  
Controls and Procedures
56
Item 9B.
Other Information.
56
     
PART III
     
Item 10.
Directors, Executive Officers and Corporate Governance
57
Item 11.
Executive Compensation
57
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
57
Item 13.
Certain Relationships and Related Transactions, and Director Independence
57
Item 14.
Principal Accounting Fees and Services
57
 
PART IV
 
Item 15.
Exhibits, Financial Statement Schedules
57
Index to Financial Statements
F-1

 

 
CAUTIONARY STATEMENT
 
All statements included or incorporated by reference in this Annual Report on Form 10-K, other than statements or characterizations of historical fact, are forward-looking statements. Examples of forward-looking statements include, but are not limited to, statements concerning projected net sales, costs and expenses and gross margins; our ability to restructure our indebtedness; our ability to continue as a going concern; our accounting estimates, assumptions and judgments; our success in pending litigation; the demand for ethanol and its co-products; the competitive nature of and anticipated growth in our industry; production capacity and goals; our ability to consummate acquisitions and integrate their operations successfully; and our prospective needs for additional capital. These forward-looking statements are based on our current expectations, estimates, approximations and projections about our industry and business, management’s beliefs, and certain assumptions made by us, all of which are subject to change. Forward-looking statements can often be identified by words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” similar expressions and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors, some of which are listed under “Risk Factors” in Item 1A of this Report. These forward-looking statements speak only as of the date of this Report. We undertake no obligation to revise or update publicly any forward-looking statement for any reason, except as otherwise required by law.
 
PART I
 
Business.
 
Recent Developments
 
Our financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As a result of ethanol industry conditions that have negatively affected our business, we do not currently have sufficient liquidity to meet our anticipated working capital, debt service and other liquidity needs in the very near-term. We have suspended operations at three of our four ethanol production facilities due to market conditions and in an effort to conserve capital. We have also taken and expect to take additional steps to preserve liquidity. However, despite any additional cost-saving steps we may take, we believe that we have sufficient working capital to continue operations only until approximately April 30, 2009 at the latest unless we successfully restructure our debt, experience a significant improvement in margins and obtain other sources of liquidity.  
 
We are in default under our construction-related term loans in the aggregate amount of approximately $230 million and under Kinergy’s revolving line of credit as well as $31.5 million in notes payable to another lender. In February 2009, we entered into forbearance agreements with each of the lenders, which were amended in March 2009, under which the lenders agreed to forbear from exercising their rights until April 30, 2009 absent further defaults. Although we are actively pursuing a number of alternatives, including seeking to restructure our debt and seeking to raise additional debt or equity financing, or both, there can be no assurance that we will be successful. If we cannot restructure our debt and obtain sufficient liquidity in the very near term, we may need to seek to protection under the U.S. Bankruptcy Code. See “Risk Factors” and “Managements Discussions and Analysis of Financial Condition and Results of Operations.”
 
-1-

 
Business Overview
 
Our primary goal is to be the leading marketer and producer of low carbon renewable fuels in the Western United States.
 
We produce and sell ethanol and its co-products, including wet distillers grain, or WDG, and provide transportation, storage and delivery of ethanol through third-party service providers in the Western United States, primarily in California, Nevada, Arizona, Oregon, Colorado, Idaho and Washington. We have extensive customer relationships throughout the Western United States and extensive supplier relationships throughout the Western and Midwestern United States.
 
Our customers are integrated oil companies and gasoline marketers who blend ethanol into gasoline. We supply ethanol to our customers either from our own ethanol production facilities located within the regions we serve, or with ethanol procured in bulk from other producers. In some cases, we have marketing agreements with ethanol producers to market all of the output of their facilities. Additionally, we have customers who purchase our co-products for animal feed and other uses.
 
According to the United States Department of Energy, or DOE, total annual gasoline consumption in the United States is approximately 140 billion gallons. Total annual ethanol consumption represented less than 7% of this amount in 2008. We believe that the domestic ethanol industry has substantial potential for growth to initially reach what we estimate is an achievable level of at least 10% of the total annual gasoline consumption in the United States, or approximately 14 billion gallons of ethanol annually and thereafter up to 36 billion gallons of ethanol annually under the new national Renewable Fuel Standards, or RFS, by 2022. See “—Governmental Regulation.”
 
In September 2008, we completed construction of our fourth ethanol facility. Our four ethanol facilities, which produce ethanol and its co-products, are as follows:
 
     
Estimated Annual
   
Date Operations
Production Capacity
Facility Name
Facility Location
Began
(gallons)
Stockton
Stockton, CA
September 2008
60,000,000
Magic Valley
Burley, ID
April 2008
60,000,000
Columbia
Boardman, OR
September 2007
40,000,000
Madera
Madera, CA
October 2006
40,000,000
 
In addition, we own a 42% interest in Front Range Energy, LLC, or Front Range, which owns a facility located in Windsor, Colorado, with annual production capacity of up to 50 million gallons. We also intend to either construct or acquire additional production facilities as financial resources and business prospects make the construction or acquisition of these facilities advisable. See “—Production Facilities.”
 
The ethanol industry has experienced significant adverse conditions over the course of the last 12 months, including prolonged negative operating margins. We, too, have experienced these adverse conditions as well as severe working capital and liquidity shortages, and in response to such conditions, we have reduced production significantly until market conditions resume to acceptable levels and working capital becomes available. We first reduced production in December 2008 and continued to reduce production through the first quarter of 2009. Currently, we have ceased production at our Madera, Magic Valley and Stockton facilities. We continue to operate our Columbia and Front Range facilities. We continue to assess market conditions and when appropriate, provided we have adequate available working capital, we plan to bring these facilities back to operation.
 
 
-2-

 
We intend to reach our goal to be the leading marketer and producer of low carbon renewable fuels in the Western United States in part by expanding our relationships with customers and third-party ethanol producers to market higher volumes of ethanol, by expanding our relationships with animal feed distributors and end users to build local markets for WDG, the primary co-product of our ethanol production, and by expanding the market for ethanol by continuing to work with state governments to encourage the adoption of policies and standards that promote ethanol as a fuel additive and transportation fuel.
 
Company History
 
We are a Delaware corporation formed in February 2005. In March 2005, we completed a transaction, or Share Exchange Transaction, with the shareholders of Pacific Ethanol, Inc., a California corporation, or PEI California, and the holders of the membership interests of each of Kinergy, LLC, or Kinergy, and ReEnergy, LLC, or ReEnergy. Upon completion of the Share Exchange Transaction, we acquired all of the issued and outstanding shares of capital stock of PEI California and all of the outstanding membership interests of each of Kinergy and ReEnergy. Immediately prior to the consummation of the Share Exchange Transaction, our predecessor, Accessity Corp., a New York corporation, or Accessity, reincorporated in the State of Delaware under the name Pacific Ethanol, Inc.
 
Our main Internet address is http://www.pacificethanol.net. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports and other Securities and Exchange Commission, or SEC, filings are available free of charge through our website as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC. Our common stock trades on the Nasdaq Global Market under the symbol PEIX. The inclusion of our website address in this Report does not include or incorporate by reference into this report any information contained on our website.
 
Competitive Strengths
 
We believe that our competitive strengths include the following:
 
 Our customer and supplier relationships. We have developed extensive business relationships with our customers and suppliers. In particular, we have developed extensive business relationships with major and independent un-branded gasoline suppliers who collectively control the majority of all gasoline sales in California and other Western states. In addition, we have developed extensive business relationships with ethanol and grain suppliers throughout the Western and Midwestern United States.
 
● Our ethanol distribution network. We believe that we have a competitive advantage due to our experience in marketing to the segment of customers in major metropolitan and rural markets in the Western United States. We have developed an ethanol distribution network for delivery of ethanol by truck to virtually every significant fuel terminal as well as to numerous smaller fuel terminals throughout California and other Western states. Fuel terminals have limited storage capacity and we have been successful in securing storage tanks at many of the terminals we service. In addition, we have an extensive network of third-party delivery trucks available to deliver ethanol throughout the Western United States.
 
● Our strategic locations. We believe that our focus on developing and acquiring ethanol production facilities in markets where local characteristics create the opportunity to capture a significant production and shipping cost advantage over competing ethanol production facilities provides us with competitive advantages, including transportation cost, delivery timing and logistical advantages as well as higher margins associated with the local sale of WDG and other co-products.
 
 
-3-

 
● Our modern technologies. Our existing production facilities use the latest production technologies to take advantage of state-of-the-art technical and operational efficiencies in order to achieve lower operating costs and more efficient production of ethanol and its co-products and reduce our use of carbon-based fuels.
 
● Our experienced management. Neil M. Koehler, our President and Chief Executive Officer, has over 20 years of experience in the ethanol production, sales and marketing industry. Mr. Koehler is a Director of the California Renewable Fuels Partnership, a Director of the Renewable Fuels Association, or RFA, and is a frequent speaker on the issue of renewable fuels and ethanol marketing and production. In addition to Mr. Koehler, we have seasoned managers with many years of experience in the ethanol, fuel, energy and feed industries, leading our various departments. We believe that the experience of our management over the past two decades and our ethanol marketing operations have enabled us to establish valuable relationships in the ethanol industry and understand the business of marketing and producing ethanol.
 
We believe that these advantages will allow us to capture an increasing share of the total market for ethanol and its co-products.
 
Business and Growth Strategy
 
Our primary goal is to be the leading marketer and producer of low carbon renewable fuels in the Western United States. Key elements of our business and growth strategy to achieve this objective include:
 
● Expand ethanol marketing revenues, ethanol markets and distribution infrastructure. We plan to increase our ethanol marketing revenues by expanding our relationships with third-party ethanol producers to market higher volumes of ethanol throughout the Western United States when market conditions are favorable. In addition, we plan to expand relationships with animal feed distributors and dairy operators to build local markets for WDG. We also plan to expand the market for ethanol by continuing to work with state governments to encourage the adoption of policies and standards that promote ethanol as a fuel additive and ultimately as a primary transportation fuel. In addition, we plan to expand our distribution infrastructure by increasing our ability to provide transportation, storage and related logistical services to our customers throughout the Western United States.
 
● Additional production capacity to meet expected future demand for ethanol. We have completed our development efforts in 2008 by building additional ethanol production facilities to meet the current and expected future demand for ethanol. This development provides us with annual production capacity of 220 million gallons, achieving our goal we set in 2005. We are also exploring opportunities to add production capacity through strategic acquisitions of existing or pending ethanol production facilities that meet our cost and location criteria.
 
● Focus on cost efficiencies. We plan to develop or acquire ethanol production facilities in markets where local characteristics create the opportunity to capture a significant production and shipping cost advantage over competing ethanol production facilities. We believe a combination of factors will enable us to achieve this cost advantage, including:
 
o  
Locations near fuel blending facilities will enable lower ethanol transportation costs and enjoy timing and logistical advantages over competing locations which require ethanol to be shipped over much longer distances.
 
o  
Locations adjacent to major rail lines will enable the efficient delivery of corn in large unit trains from major corn-producing regions.
 
o  
Locations near large concentrations of dairy and/or beef cattle will enable delivery of WDG over short distances without the need for costly drying processes.
 
-4-

 
In addition to these location-related efficiencies, we have incorporate advanced design elements into our new production facilities to take advantage of state-of-the-art technical and operational efficiencies.
 
● Explore new technologies and renewable fuels. We are evaluating a number of technologies that may increase the efficiency of our ethanol production facilities and reduce our use of carbon-based fuels. In addition, we are exploring the feasibility of using different and potentially abundant and cost-effective feedstocks, such as cellulosic plant biomass, to supplement corn as the basic raw material used in the production of ethanol. On January 29, 2008, the DOE awarded us $24.3 million in matching funds to build the first cellulosic ethanol demonstration plant in the Northwest United States.
 
● Employ risk mitigation strategies. As sufficient working capital is available, we seek to mitigate our exposure to commodity price fluctuations by purchasing forward a portion of our corn and natural gas requirements through fixed-price contracts with our suppliers, as well as, entering into derivative instruments to fix or establish a range of corn and natural gas prices. To mitigate ethanol inventory price risks, we may sell a portion of our production forward under fixed- or index-price contracts, or both. We may hedge a portion of the price risks associated with index-price contracts by selling exchange-traded unleaded gasoline futures contracts. Proper execution of these risk mitigation strategies can reduce the volatility of our gross profit margins.
 
● Evaluate and pursue acquisition opportunities. We intend to evaluate and pursue opportunities to acquire additional ethanol production, storage and distribution facilities and related infrastructure as financial resources and business prospects make the acquisition of these facilities advisable. In addition, we may also seek to acquire facility sites under development.
 
Industry Overview and Market Opportunity
 
Overview of Ethanol Market
 
The primary applications for fuel-grade ethanol in the United States include:
 
● Octane enhancer. On average, regular unleaded gasoline has an octane rating of 87 and premium unleaded has an octane rating of 91. In contrast, pure ethanol has an average octane rating of 113. Adding ethanol to gasoline enables refiners to produce greater quantities of lower octane blend stock with an octane rating of less than 87 before blending. In addition, ethanol is commonly added to finished regular grade gasoline as a means of producing higher octane mid-grade and premium gasoline.
 
● Renewable fuels. Ethanol is blended with gasoline in order to enable gasoline refiners to comply with a variety of governmental programs, in particular, the national RFS designed to promote alternatives to fossil fuels. See “—Governmental Regulation.”
 
● Fuel blending. In addition to its performance and environmental benefits, ethanol is used to extend fuel supplies. As the need for automotive fuel in the United States increases and the dependence on foreign crude oil and refined products grows, the United States is increasingly seeking domestic sources of fuel. Much of the ethanol blending throughout the United States is done for the purpose of extending the volume of fuel sold at the gasoline pump. Furthermore, conditions in Brazil, where ethanol accounts for 40% of the gasoline market and is sold in blends with gasoline ranging from 25% to 100%, suggest that ethanol could capture a much greater portion of the United States market in the future.
 
 
-5-

 
The ethanol fuel industry is greatly dependent upon tax policies and environmental regulations that favor the use of ethanol in motor fuel blends in the United States. See “—Governmental Regulation.” Ethanol blends have been either wholly or partially exempt from the federal excise tax on gasoline since 1978. The current federal excise tax on gasoline is $0.184 per gallon and is paid at the terminal by refiners and marketers. If the fuel is blended with ethanol, the blender may claim a $0.45 per gallon tax credit for each gallon of ethanol used in the mixture. Federal law also requires the sale of oxygenated fuels in certain carbon monoxide non-attainment Metropolitan Statistical Areas, or MSAs, during at least four winter months, typically November through February.
 
In addition, the Energy Independence and Security Act of 2007, which was signed into law in December 2007, significantly increased the prior national RFS. The new national RFS significantly increases the mandated use of renewable fuels to 11.1 billion gallons in 2009 and 13.0 billion gallons in 2010, and rises incrementally and peaks at 36.0 billion gallons by 2022. The new national RFS mandates include renewable fuel increases, with corn-based or “conventional” ethanol to 10.5 billion gallons in 2009 and 12.0 billion gallons in 2010, reaching a peak of 15.0 billion gallons by 2015. Beginning in 2016, increases in the new national RFS targets must be met with advanced biofuels, defined as cellulosic ethanol and other biofuels derived from feedstock other than corn starch. We believe that these increases will bolster demand for ethanol.
 
In January 2007, California’s Governor signed an executive order directing the California Air Resource Board to implement a Low Carbon Fuels Standard for transportation fuels. The Governor’s office estimates that the standard will have the effect of increasing current renewable fuels use in California by three to five times by 2020. The State of Oregon implemented a state-wide renewable fuels standard effective January 2008. This standard requires a 10% ethanol blend in every gallon of gasoline and is expected to cause the use of approximately 160 million gallons of ethanol per year in Oregon.
 
According to the RFA, the domestic ethanol industry produced approximately 9.2 billion gallons of ethanol in 2008, an increase of approximately 42% from the approximately 6.5 billion gallons of ethanol produced in 2007. We believe that the ethanol market in California alone consumed approximately 1.1 billion gallons in 2008, representing approximately 12% of the national market. However, the Western United States has relatively few ethanol facilities and local ethanol production levels are substantially below the local demand for ethanol. The balance of ethanol is shipped via rail from the Midwest to the Western United States. Gasoline and diesel fuel that supply the major fuel terminals are shipped in pipelines throughout portions of the Western United States. Unlike gasoline and diesel fuel, however, ethanol is not shipped in these pipelines because ethanol has an affinity for mixing with water already present in the pipelines. When mixed, water dilutes ethanol and creates significant quality control issues. Therefore, ethanol must be trucked from rail terminals to regional fuel terminals, or blending racks.
 
We believe that approximately 90% of the ethanol produced in the United States is made in the Midwest from corn. According to the DOE, ethanol is typically blended at 5.7% to 10% by volume, but is also blended at up to 85% by volume for vehicles designed to operate on 85% ethanol. Compared to gasoline, ethanol is generally considered to be cleaner burning and contains higher octane. We anticipate that the increasing demand for transportation fuels coupled with limited opportunities for gasoline refinery expansions and the growing importance of reducing CO2 emissions through the use of renewable fuels will generate additional growth in the demand for ethanol in the Western United States.
 
Ethanol prices, net of tax incentives offered by the federal government, are generally positively correlated to fluctuations in gasoline prices. In addition, we believe that ethanol prices in the Western United States are typically $0.15 to $0.20 per gallon higher than in the Midwest due to the freight costs of delivering ethanol from Midwest production facilities.
 
 
-6-

 
According to the DOE, total annual gasoline consumption in the United States is approximately 140 billion gallons and total annual ethanol consumption represented less than 7% of this amount in 2008. We believe that the domestic ethanol industry has substantial potential for growth to initially reach what we estimate is an achievable level of at least 10% of the total annual gasoline consumption in the United States, or approximately 14 billion gallons of ethanol annually and thereafter up to 36 billion gallons of ethanol annually required under the new national RFS by 2022.
 
While we believe that the overall national market for ethanol will grow, we believe that the market for ethanol in certain geographic areas such as California could experience either increases or decreases in demand depending on the preferences of petroleum refiners and state policies. See “Risk Factors.”
 
Overview of Ethanol Production Process
 
The production of ethanol from starch- or sugar-based feedstocks has been refined considerably in recent years, leading to a highly-efficient process that we believe now yields substantially more energy in the ethanol and co-products than is required to make the products. The modern production of ethanol requires large amounts of corn, or other high-starch grains, and water as well as chemicals, enzymes and yeast, and denaturants such as unleaded gasoline or liquid natural gas, in addition to natural gas and electricity.
 
In the dry milling process, corn or other high-starch grains are first ground into meal and then slurried with water to form a mash. Enzymes are then added to the mash to convert the starch into the simple sugar, dextrose. Ammonia is also added for acidic (pH) control and as a nutrient for the yeast. The mash is processed through a high temperature cooking procedure, which reduces bacteria levels prior to fermentation. The mash is then cooled and transferred to fermenters, where yeast is added and the conversion of sugar to ethanol and CO2 begins.
 
After fermentation, the resulting “beer” is transferred to distillation, where the ethanol is separated from the residual “stillage.” The ethanol is concentrated to 190 proof using conventional distillation methods and then is dehydrated to approximately 200 proof, representing 100% alcohol levels, in a molecular sieve system. The resulting anhydrous ethanol is then blended with about 5% denaturant, which is usually gasoline, and is then ready for shipment to market.
 
The residual stillage is separated into a coarse grain portion and a liquid portion through a centrifugation process. The soluble liquid portion is concentrated to about 40% dissolved solids by an evaporation process. This intermediate state is called condensed distillers solubles, or syrup. The coarse grain and syrup portions are then mixed to produce WDG or can be mixed and dried to produce dried distillers grains with solubles, or DDGS. Both WDG and DDGS are high-protein animal feed products.
 
Overview of Distillers Grains Market
 
According to the National Corn Growers Association, approximately 15 million tons of dried distillers grains were produced during the 2007 and 2008 crop year and fed to livestock. Last year, an estimated 720 million bushels of corn from feed rations was displaced with these distillers grains, allowing the corn to be used in other markets.
 
In the United States, most distillers grains are produced in the Midwest, where producers dry the grains before shipping. Successful and profitable delivery of DDGS from the Midwest faces a number of challenges, including product inconsistency, handling difficulty and lower feed values. By not drying the distillers grains and by shipping WDG locally, we believe that we will be able to preserve the feed integrity of these grains.
 
 
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Historically, the market price for distillers grains has been stable in comparison to the market price for ethanol. We believe that the market price of DDGS is determined by a number of factors, including the market value of corn, soybean meal and other competitive ingredients, the performance or value of DDGS in a particular feed formulation and general market forces of supply and demand. We also believe that nationwide, the market price of distillers grains historically has been influenced by producers of distilled spirits and more recently by the large corn dry-millers that operate fuel ethanol facilities. The market price of distillers grains is also often influenced by nutritional models that calculate the feed value of distillers grains by nutritional content.
 
Customers
 
We produce and also purchase from third-parties and resell ethanol to various customers in the Western United States. We also arrange for transportation, storage and delivery of ethanol purchased by our customers through our agreements with third-party service providers. Our revenue is obtained primarily from sales of ethanol to large oil companies. We began producing ethanol in the fourth quarter of 2006.
 
During 2008, 2007 and 2006, we produced or purchased from third parties and resold an aggregate of approximately 272 million, 191 million and 102 million gallons of fuel-grade ethanol to approximately 66 customers, 61 customers and 60 customers, respectively. Sales to our two largest customers in 2008 and in 2007 represented approximately 32% of our net sales for each of those years. Sales to our two largest customers in 2006 represented approximately 25% of our net sales. Customers who accounted for 10% or more of our net sales in 2008 and 2007 were Chevron Products USA and Valero Marketing. Customers who accounted for 10% or more of our net sales in 2006 were New West Petroleum and Chevron Products USA. Sales to each of our other customers represented less than 10% of our net sales in each of 2008, 2007 and 2006.
 
Most of the major metropolitan areas in the Western United States have fuel terminals served by rail, but other major metropolitan areas and more remote smaller cities and rural areas do not. We believe that we have a competitive advantage due to our experience in marketing to the segment of customers in major metropolitan and rural markets in the Western United States. We manage the complicated logistics of shipping ethanol purchased from third-parties from the Midwest by rail to intermediate storage locations throughout the Western United States and trucking the ethanol from these storage locations to blending racks where the ethanol is blended with gasoline. We believe that by establishing an efficient service for truck deliveries to these more remote locations, we have differentiated ourselves from our competitors. In addition, by producing ethanol in the Western United States, we believe that we will benefit from our ability to increase spot sales of ethanol from this additional supply following ethanol price spikes caused from time to time by rail delays in delivering ethanol from the Midwest to the Western United States. In addition to producing ethanol, we produce ethanol co-products such as WDG. We endeavor to position WDG as the protein feed of choice for cattle based on its nutritional composition, consistency of quality and delivery, ease of handling and its mixing ability with other feed ingredients. We expect to be one of the few WDG producers with production facilities located in the Western United States and we primarily sell our WDG to dairy farmers in close proximity to our ethanol production facilities.
 
Suppliers
 
Our marketing operations are dependent upon various producers of fuel-grade ethanol for our ethanol supplies. In addition, we provide ethanol transportation, storage and delivery services through third-party service providers with whom we have contracted to receive ethanol at agreed upon locations from our suppliers and to store and/or deliver the ethanol to agreed upon locations on behalf of our customers. These contracts generally run from year-to-year, subject to termination by either party upon advance written notice before the end of the then-current annual term. We also transport ethanol with our own fleet of railcars, which we intend to expand to support the continuing growth of our business.
 
 
-8-

 
During 2008, 2007 and 2006, we purchased fuel-grade ethanol and corn, the largest component in producing ethanol, from our suppliers. Purchases from our two largest suppliers in 2008 represented approximately 49% of our total ethanol and corn purchases. Purchases from our three largest ethanol and corn suppliers in 2007 represented approximately 47% of our total ethanol and corn purchases. Purchases from our three largest ethanol suppliers in 2006 represented approximately 50% of our total ethanol and corn purchases. Purchases from each of our other suppliers represented less than 10% of total ethanol and corn purchases in 2008, 2007 and 2006.
 
Our ethanol production operations are dependent upon various raw materials suppliers, including suppliers of corn, natural gas, electricity and water. The cost of corn is the most important variable cost associated with the production of ethanol. An ethanol plant must be able to efficiently ship corn from the Midwest via rail and cheaply and reliably truck ethanol to local markets. We believe that our existing grain receiving facilities at our ethanol facilities are some of the most efficient grain receiving facilities in the United States. We source corn using standard contracts, such as spot purchases, forward purchases and basis contracts. When we have the resources to do so, we seek to limit our exposure to raw material price fluctuations by purchasing forward a portion of our corn requirements on a fixed price basis and by purchasing corn and other raw materials futures contracts. In addition, to help protect against supply disruptions, we may maintain inventories of corn at each of our facilities.
 
Production Facilities
 
The table below provides an overview of our ethanol production facilities.
 
 
Madera
Facility
 
 
Front Range
Facility(1)
 
 
Columbia
Facility
 
 
Magic
Valley
Facility
 
 
Stockton
Facility
Location
Madera, CA
 
Windsor, CO
 
Boardman, OR
 
Burley, ID
 
Stockton, CA
Quarter/Year operations began
4th Qtr., 2006
 
2nd Qtr., 2006
 
3rd Qtr., 2007
 
2nd Qtr., 2008
 
3rd Qtr., 2008
Annual design basis ethanol production capacity (in millions of gallons)
35
 
40
 
35
 
50
 
50
Approximate maximum annual ethanol production capacity (in millions of gallons)
40
 
50
 
40
 
60
 
60
Ownership
100%
 
42%
 
100%
 
100%
 
100%
Primary energy source
Natural Gas
 
Natural Gas
 
Natural Gas
 
Natural Gas
 
Natural Gas
Estimated annual WDG production capacity (in thousands of tons)
293
 
335
 
293
 
418
 
418
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(1)   We own 42% of Front Range, the entity that owns the facility located in Windsor, Colorado.
 
The ethanol industry has experienced significant adverse conditions over the course of the last 12 months, including prolonged negative operating margins. We, too, have experienced these adverse conditions as well as severe working capital and liquidity shortages, and in response to such conditions, we have reduced production significantly until market conditions resume to acceptable levels and working capital becomes available. We first reduced production in December 2008 and continued to reduce production through the first quarter of 2009. Currently, we have ceased production at our Madera, Magic Valley and Stockton facilities.  We continue to operate our Columbia and Front Range facilities. We continue to assess market conditions and when appropriate, provided we have adequate available working capital, we plan to bring these facilities back to operation.
 
 
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Site Location Criteria
 
Our site location criteria encompass many factors, including proximity of fuel blending facilities and major rail lines, good road access, water and utility availability and adequate space for equipment and truck movement. One of our primary business and growth strategies is to develop or acquire ethanol production facilities in markets where local characteristics create the opportunity to capture a significant production and shipping cost advantage over competing ethanol production facilities. Therefore, it is critical that our production sites are located near fuel blending facilities in the Western United States because many of our competitors ship ethanol over long distances from the Midwest. Also, close proximity to major rail lines to receive corn shipments from Midwest producers is critical.
 
Marketing Arrangements
 
We have exclusive agreements with third-party ethanol producers, including Calgren Renewable Fuels, LLC and Front Range, the latter of which we are a minority owner, to market and sell their entire ethanol production volumes. Calgren Renewable Fuels, LLC owns and operates an ethanol production facility in Pixley, California with annual production capacity of 55 million gallons. Front Range owns and operates an ethanol production facility in Windsor, Colorado with annual production capacity of 50 million gallons. We also have an exclusive agreement to market and sell WDG produced at the facility owned by Front Range. We intend to evaluate and pursue opportunities to enter into marketing arrangements with other ethanol producers as business prospects make these marketing arrangements advisable.
 
Competition
 
We operate in the highly competitive ethanol marketing and production industry. The largest ethanol producer in the United States is ADM, with wet and dry mill plants in the Midwest and a total production capacity of about 1.25 billion gallons per year, or approximately 14% of total United States ethanol production in 2008. According to the RFA, there are approximately 170 ethanol facilities currently operating with a combined annual production capacity of approximately 10.6 billion gallons. In addition, we believe that approximately five new ethanol facilities or expansions of existing facilities are currently under construction with an estimated combined future annual production capacity of approximately 1.0 billion gallons.
 
We believe that many smaller ethanol facilities rely on marketing groups such as POET Ethanol Products, Aventine Renewable Energy, Inc., Eco Energy and Renewable Products Marketing Group LLC to move their product to market. We believe that, because ethanol is a commodity, many of the Midwest ethanol producers can target the Western United States, though ethanol producers further west in states such as Nebraska and Kansas often enjoy delivery cost advantages.
 
In the second half of 2008 and into the first quarter of 2009, we and our competitors have reduced production and/or experienced significant working capital deficits. Some of our competitors have filed for protection under the United States Bankruptcy Code. As a result, our competition may change in the near term by either further declining production or entrance by others in the marketplace, for example, through purchases of facilities through liquidation. These competitors may even be some of our current customers.
 
We believe that our competitive strengths include our strategic locations in the Western United States, our extensive ethanol distribution network, our extensive customer and supplier relationships, our use of modern technologies at our production facilities and our experienced management. We believe that these advantages will allow us to capture an increasing share of the total market for ethanol and its co-products and earn favorable margins on ethanol and its co-products that we produce.
 
 
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Our strategic focus on particular geographic locations designed to exploit cost efficiencies may nevertheless result in higher than expected costs as a result of more expensive raw materials and related shipping costs, such as corn, which generally must be transported from the Midwest. If the costs of producing and shipping ethanol and its co-products over short distances are not advantageous relative to the costs of obtaining raw materials from the Midwest, then the planned benefits of our strategic locations may not be realized.
 
Governmental Regulation
 
Our business is subject to extensive and frequently changing federal, state and local laws and regulations relating to the protection of the environment. These laws, their underlying regulatory requirements and their enforcement, some of which are described below, impact, or may impact, our existing and proposed business operations by imposing:
 
  
restrictions on our existing and proposed business operations and/or the need to install enhanced or additional controls;
  
the need to obtain and comply with permits and authorizations;
  
liability for exceeding applicable permit limits or legal requirements, in certain cases for the remediation of contaminated soil and groundwater at our facilities, contiguous and adjacent properties and other properties owned and/or operated by third parties; and
  
specifications for the ethanol we market and produce.
 
In addition, some of the governmental regulations to which we are subject are helpful to our ethanol marketing and production business. The ethanol fuel industry is greatly dependent upon tax policies and environmental regulations that favor the use of ethanol in motor fuel blends in North America. Some of the governmental regulations applicable to our ethanol marketing and production business are briefly described below.
 
Federal Excise Tax Exemption
 
Ethanol blends have been either wholly or partially exempt from the federal excise tax on gasoline since 1978. The exemption has ranged from $0.04 to $0.06 per gallon of gasoline during that 25-year period. The current federal excise tax on gasoline is $0.184 per gallon, and is paid at the terminal by refiners and marketers. If the fuel is blended with ethanol, the blender may claim a $0.45 per gallon tax credit for each gallon of ethanol used in the mixture. The federal excise tax exemption was revised and its expiration date was extended for the sixth time since its inception as part of the American Jobs Creation Act of 2004. The new expiration date of the federal excise tax exemption is December 31, 2010. We believe that it is highly likely that this tax incentive will be extended beyond 2010 if Congress deems it necessary for the continued growth and prosperity of the ethanol industry.
 
Clean Air Act Amendments of 1990
 
In November 1990, a comprehensive amendment to the Clean Air Act of 1977 established a series of requirements and restrictions for gasoline content designed to reduce air pollution in identified problem areas of the United States. The two principal components affecting motor fuel content are the oxygenated fuels program, which is administered by states under federal guidelines, and a federally supervised reformulated gasoline, or RFG, program.
 
Oxygenated Fuels Program
 
Federal law requires the sale of oxygenated fuels in certain carbon monoxide non-attainment MSAs during at least four winter months, typically November through February. Any additional MSAs not in compliance for a period of two consecutive years in subsequent years may also be included in the program. The Environmental Protection Agency, or EPA, Administrator is afforded flexibility in requiring a shorter or longer period of use depending upon available supplies of oxygenated fuels or the level of non-attainment. This law currently affects the Los Angeles area, where over 150 million gallons of ethanol are blended with gasoline each winter.
 
 
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Reformulated Gasoline Program
 
The Clean Air Act Amendments of 1990 established special standards effective January 1, 1995 for the most polluted ozone non-attainment areas: Los Angeles Area, Baltimore, Chicago Area, Houston Area, Milwaukee Area, New York City Area, Hartford, Philadelphia Area and San Diego, with provisions to add other areas in the future if conditions warrant. California’s San Joaquin Valley, the location of both of our Madera and Stockton facilities, was added in 2002. At the outset of the RFG program there were a total of 96 MSAs not in compliance with clean air standards for ozone, which represents approximately 60% of the national market.
 
The RFG program also includes a provision that allows individual states to “opt into” the federal program by request of the governor, to adopt standards promulgated by California that are stricter than federal standards, or to offer alternative programs designed to reduce ozone levels. Nearly the entire Northeast and middle Atlantic areas from Washington, D.C. to Boston not under the federal mandate have “opted into” the federal standards.
 
These state mandates in recent years have created a variety of gasoline grades to meet different regional environmental requirements. The RFG program accounts for about 30% of nationwide gasoline consumption. California refiners blend a minimum of 2.0% oxygen by weight, which is the equivalent of 5.7% ethanol in every gallon of gasoline, or roughly 1.0 billion gallons of ethanol per year in California alone.
 
National Energy Legislation
 
In addition, the Energy Independence and Security Act of 2007, which was signed into law in December 2007, significantly increased the prior national RFS. The new national RFS significantly increases the mandated use of renewable fuels to 11.1 billion gallons in 2009 and 13.0 billion gallons in 2010, and rises incrementally and peaks at 36.0 billion gallons by 2022. The new national RFS mandates include renewable fuel increases, with corn-based or “conventional” ethanol to 10.5 billion gallons in 2009 and 12.0 billion gallons in 2010, reaching a peak of 15.0 billion gallons by 2015. Beginning in 2016, increases in the new national RFS targets must be met with advanced biofuels, defined as cellulosic ethanol and other biofuels derived from feedstock other than corn starch.
 
State Energy Legislation and Regulations
 
State energy legislation and regulations may affect the demand for ethanol. California recently passed legislation regulating the total emissions of CO2 from vehicles and other sources. In 2006, the State of Washington passed a statewide renewable fuel standard effective December 1, 2008. We believe other states may also enact their own renewable fuel standards.
 
In January 2007, California’s Governor signed an executive order directing the California Air Resource Board to implement a Low Carbon Fuels Standard for transportation fuels. The Governor’s office estimates that the standard will have the effect of increasing current renewable fuels use in California by three to five times by 2020.
 
The State of Oregon implemented a state-wide renewable fuels standard effective January 2008. This standard requires a 10% ethanol blend in every gallon of gasoline and is expected to cause the use of approximately 160 million gallons of ethanol per year in Oregon.
 
 
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Additional Environmental Regulations
 
In addition to the governmental regulations applicable to the ethanol marketing and production industries described above, our business is subject to additional federal, state and local environmental regulations, including regulations established by the EPA, the Regional Water Quality Control Board, the San Joaquin Valley Air Pollution Control District and the California Air Resources Board. We cannot predict the manner or extent to which these regulations will harm or help our business or the ethanol production and marketing industry in general.
 
Employees
 
As of March 26, 2009, we employed approximately 150 persons on a full-time basis, including through our subsidiaries. We believe that our employees are highly-skilled, and our success will depend in part upon our ability to retain our employees and attract new qualified employees who are in great demand. We have never had a work stoppage or strike, and no employees are presently represented by a labor union or covered by a collective bargaining agreement. We consider our relations with our employees to be good.
 
Risk Factors.
 
Risks Related to our Business
 
There is substantial doubt as to our ability to continue as a going concern. We need additional financing or capital which may be unavailable or costly.
 
As a result of ethanol industry conditions that have negatively affected our business, we do not currently have sufficient liquidity to meet our anticipated working capital, debt service and other liquidity needs in the very near-term. We believe that we have sufficient working capital to continue operations only until approximately April 30, 2009 at the latest unless we successfully restructure our debt, experience a significant improvement in margins and obtain other sources of liquidity. In addition, although various secured creditors are presently forbearing through April 30, 2009 under outstanding forbearance agreements from exercising their rights, once those forbearance periods expire or in the event of additional defaults, we will be in default to those secured creditors who collectively hold security interests in substantially all of our assets. As a result, our 2008 financial statements include an explanatory paragraph by our independent registered public accounting firm describing the substantial doubt as to our ability to continue as a going concern.
 
As of March 26, 2009, we owed approximately $246.5 million in term loans and lines of credit associated with the construction and operation of our ethanol plants and approximately $5.3 million under our revolving credit facility. As of that date, we had only $4.0 million in cash and $4.7 million of additional borrowing availability under our revolving credit facility. As we continue to reduce the number of gallons of ethanol we sell and hold in inventory, working capital available to support borrowings under our revolving credit facility will reduce proportionately.
 
We do not expect to have sufficient liquidity to meet anticipated working capital, debt service and other liquidity needs beyond April 30, 2009 at the latest unless we successfully restructure our debt, experience a significant improvement in margins and obtain other sources of liquidity. Based on the current spread between corn and ethanol prices, the industry is operating at or near break-even cash margins. The current spread between ethanol and corn prices cannot support the long-term viability of the U.S. ethanol industry in general or us in particular.   
 
Although we are actively pursuing a number of alternatives, including seeking to restructure our debt and seeking to raise additional debt or equity financing, or both, there can be no assurance that we will be successful. If we cannot restructure our debt and obtain sufficient liquidity in the very near term, we may need to seek to protection under the U.S. Bankruptcy Code.
 
 
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If we seek protection under the U.S. Bankruptcy Code, all of our outstanding shares of capital stock could be cancelled and holders of our capital stock may not be entitled to any payment in respect of their shares.
 
If we seek protection under the U.S. Bankruptcy Code it is possible that all of our outstanding shares of capital stock could be cancelled and holders of capital stock may not be entitled to any payment in respect of their shares. It is also possible that our obligations to our creditors may be satisfied by the issuance of shares of capital stock in satisfaction of their claims. The value of any capital stock so issued may be less than the face value of our obligations to those creditors, and the price of any such capital stock may be volatile. In addition, in the event of a bankruptcy filing, our common stock will be suspended from trading on and delisted from NASDAQ. Accordingly, trading in our common stock may be limited, and our stockholders may not be able to resell their securities for their purchase price or at all.
 
We are seeking additional financing and may be unable to obtain this financing on a timely basis, in sufficient amounts, on terms acceptable to us or at all. Any financing we are able to obtain may be available only on burdensome terms that may cause significant dilution to our stockholders and impose onerous financial restrictions on our business.
 
We are seeking substantial additional financing. Deteriorating global economic and debt and equity market conditions may cause prolonged declines in lender and investor confidence in and accessibility to capital markets. Future financing may not be available on a timely basis, in sufficient amounts, on terms acceptable to us or at all. Any equity financing may cause significant dilution to existing stockholders. Any debt financing or other financing of securities senior to our common stock will likely include financial and other covenants that will restrict our flexibility. At a minimum, we would expect these covenants to include restrictions on our ability to pay dividends on our common stock. Any failure to comply with these covenants could have a material adverse effect on our business, prospects, financial condition and results of operations because we could lose any then-existing sources of financing and our ability to secure new financing may be impaired. In addition, any prospective debt or equity financing transaction will be subject to the negotiation of definitive documents and any closing under those documents will be subject to the satisfaction of numerous conditions, many of which could be beyond our control. We may be unable to obtain additional financing from one or more lenders or equity investors, or if funding is available, it may be available only on burdensome terms that may cause significant dilution to our stockholders and impose onerous financial restrictions on our business.
 
We have incurred significant losses and negative operating cash flow in the past and we will likely incur significant losses and negative operating cash flow in the foreseeable future. Continued losses and negative operating cash flow will hamper our operations and prevent us from expanding our business.
 
We have incurred significant losses and negative operating cash flow in the past. For the years ended December 31, 2008, 2007 and 2006, we incurred net losses of approximately $146.5 million, $14.4 million and $142,000, respectively. For the years ended December 31, 2008 and 2006, we incurred negative operating cash flow of approximately $55.2 million and $8.1 million, respectively. We will likely incur significant losses and negative operating cash flow in the foreseeable future. We expect to rely on cash on hand, cash, if any, generated from our operations and cash, if any, generated from our future financing activities to fund all of the cash requirements of our business. Continued losses and negative operating cash flow will hamper our operations and prevent us from expanding our business. Continued losses and negative operating cash flow are also likely to make our capital raising needs more acute while limiting our ability to raise additional financing on satisfactory terms.
 
 
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We recognized impairment charges in 2008 and could recognize additional impairment charges in the future.
 
During 2008, we recognized an impairment charge of our goodwill in the amount of $87.0 million and an impairment charge on our construction project in the Imperial Valley near Calipatria, California, or the Imperial Project, in the amount of $40.9 million. As of December 31, 2008, we performed our forecast of expected future cash flows of our facilities over their estimated useful lives. Such forecasts of expected future cash flows are heavily dependent upon management’s estimates of future market prices for ethanol, our primary product, and corn, our primary production input. As both ethanol and corn costs have fluctuated significantly in the past year, these estimates are highly subjective and are management’s best estimates at this time.
 
If average prices for ethanol and corn during 2008 were used in our forecast rather than management’s estimate of future market prices, the projections would have resulted in estimated undiscounted cash flows below carrying values which would require us to compute their fair values. If we are required to compute the fair value in the future, we may use the work of a qualified valuation specialist who would assist us in examining replacement costs, recent transactions between third parties and cash flow that can be generated from operations. Given the recent completion of the facilities, replacement cost would likely approximate the carrying value of the facilities. However, there have been recent transactions between independent parties to purchase plants at prices substantially below the carrying value of the facilities. Some of the facilities have been in bankruptcy and may not be representative of transactions outside of bankruptcy. Given these circumstances, should management be required to adjust the carrying value of the facilities to fair value at some future point in time, the adjustment could be significant and could significantly impact our financial position, results of operations and possibly any existing financial debt covenants.
 
If we are unable to attract and retain key personnel, our ability to operate effectively may be impaired.
 
Our ability to operate our business and implement strategies depends, in part, on the efforts of our executive officers and other key employees.  We have made certain reductions in staffing which may have had the effect of creating an uncertain employment environment, which may lead key employees to seek alternative employment. In addition, our acute financial distress may cause key employees to seek alternative employment. Our future success will depend on, among other factors, our ability to attract and retain our current key personnel and qualified future key personnel, particularly executive management.  Failure to attract or retain qualified key personnel, could have a material adverse effect on our business and results of operations.
 
Even if we are able to restructure our indebtedness and raise additional capital in the very near term, various factors could result in inadequate working capital to fully fund our operations.
 
If ethanol production margins remain at or deteriorate from current levels, if our capital requirements or cash flows otherwise vary materially and adversely from our current projections, or if other adverse unforeseen circumstances occur, our working capital may be inadequate to fully fund our operations even if we are able to restructure our indebtedness and raise additional capital in the very near term, which may have a material adverse effect on our results of operations, liquidity and cash flows and may restrict our growth and hinder our ability to compete.
 
 
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The crisis in the financial markets, considerable volatility in the commodities markets and sustained weakening of the economy could further significantly impact our business and financial condition and may limit our ability to raise additional capital.
 
As widely reported, financial markets in the United States and the rest of the world are experiencing extreme disruption, including, among other things, extreme volatility in securities and commodities prices, as well as severely diminished liquidity and credit availability. As a result, we believe that our ability to access capital markets and raise funds required for our operations is severely restricted at a time when we need to do so, which is having a material adverse effect on our ability to meet our current and future funding requirements and on our ability to react to changing economic and business conditions. Current economic and market conditions, and particularly, the significant decline in the price of crude oil, has resulted in reduced demand for our products. We are not able to predict the duration or severity of the current disruption in financial markets, fluctuations in the price of crude oil or other adverse economic conditions in the United States. However, if economic conditions continue to worsen, it is likely that these factors would have a further adverse effect on our results of operations and future prospects.
 
Increased ethanol production 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 in recent years. Domestic ethanol production capacity has increased steadily from an annualized rate of 1.7 billion gallons per year in January 1999 to 9.2 billion gallons in 2008 according to the RFA. In addition, we believe that a significant amount of ethanol production capacity—approximately 1.0 billion gallons per year—is currently under construction. This production capacity is being added to address anticipated increases in demand, including demand from increased volume requirements under the Energy Independence and Security Act of 2007. See “Business—Governmental Regulation.” However, increases in the demand for ethanol may not be commensurate with increases in the supply of ethanol, thus leading to lower ethanol prices. 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. Increased ethanol production could also have other adverse effects. For example, increased ethanol production could lead to increased supplies of co-products generated from ethanol production, such as WDG. Those increased supplies could lead to lower prices for those co-products. Also, increased ethanol production could result in increased demand for corn. Increased demand for corn could cause higher corn prices, resulting in higher ethanol production costs and lower profit margins. Accordingly, increased ethanol production 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.
 
The raw materials and energy necessary to produce ethanol may be unavailable or may increase in price, adversely affecting our business, results of operations and financial condition.
 
The principal raw material we use to produce ethanol and its co-products is corn. Changes in the price of corn can significantly affect our business. In general, and as we have experienced in 2008, rising corn prices result in lower profit margins and, therefore, represent unfavorable market conditions. This is especially true since market conditions generally do not allow us to pass along increased corn prices to our customers because the price of ethanol is primarily determined by other factors, such as the supply of ethanol and the price of oil and gasoline. At certain levels, corn prices may even make ethanol production uneconomical depending on the prevailing price of ethanol.
 
 
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The price of corn is influenced by general economic, market and regulatory factors. These factors include weather conditions, crop conditions and yields, farmer planting decisions, government policies and subsidies with respect to agriculture and international trade and global supply and demand. The significance and relative impact of these factors on the price of corn is difficult to predict. Any event that tends to negatively impact the supply of corn will tend to increase prices and potentially harm our business. Average corn prices as measured by the Chicago Board of Trade increased 41% from 2007 to 2008. The United States Department of Agriculture’s March 2009 World Agriculture Supply and Demand Estimates projected that corn bought by ethanol plants in the U.S. will represent approximately 31% of the 2008/2009 crop year’s total corn supply, up from 22% in the prior crop year. Additional increases in ethanol production could further boost demand for corn and result in further increases in corn prices.
 
Our business also depends on the continuing availability of rail, road, port, storage and distribution infrastructure. In particular, due to limited storage capacity at our production facilities and other considerations related to production efficiencies, we depend on just-in-time delivery of corn. The production of ethanol also requires a significant and uninterrupted supply of other raw materials and energy, primarily water, electricity and natural gas. The prices of electricity and natural gas have fluctuated significantly in the past and may fluctuate significantly in the future. Local water, electricity and gas utilities may not be able to reliably supply the water, electricity and natural gas that our facilities will need or may not be able to supply those resources on acceptable terms. Any disruptions in the ethanol production infrastructure network, 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 may require us to halt production which could have a material adverse effect on our business, results of operations and financial condition.
 
We engage in hedging transactions and other risk mitigation strategies that could harm our results of operations.
 
In an attempt to partially offset the effects of volatility of ethanol prices and corn and natural gas costs, we often enter into contracts to supply a portion of our ethanol production or purchase a portion of our corn or natural gas requirements on a forward basis. In addition, we 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 we have futures contracts. We also engage in hedging transactions involving interest rate swaps related to our debt financing activities, the financial statement impact of which is dependent upon, among other things, fluctuations in prevailing interest rates. 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. Hedging activities can themselves result in losses when a position is purchased in a declining market or a position is sold in a rising market. A hedge position for a physical commodity is often settled in the same time frame as the physical commodity is either purchased or sold. Certain hedging losses may be offset by a decreased cash price for corn and natural gas and an increased cash price for ethanol. We also vary the amount of hedging or other risk mitigation strategies we undertake, and from time to time we may choose not to engage in hedging transactions at all. As a result, our results of operations and financial position may be adversely affected by fluctuations in the price of corn, natural gas, ethanol, unleaded gasoline and prevailing interest rates.
 
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, our average sales price of ethanol in 2008 increased by 5%, in 2007 declined by 6% and in 2006 increased by 37% from the prior year’s average sales price per gallon. Fluctuations in the market price of ethanol may cause our profitability or losses to fluctuate significantly.
 
 
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We have identified certain material weaknesses in our internal control over financial reporting in the past and cannot assure you that material weaknesses will not be identified in the future. If our internal control over financial reporting or disclosure controls and procedures are not effective, there may be errors in our financial statements that could require a restatement or our filings may not be timely and investors may lose confidence in our reported financial information, which could lead to a decline in our stock price.
 
Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal control over financial reporting as of the end of each year, and to include a management report assessing the effectiveness of our internal control over financial reporting in each Annual Report on Form 10-K. Section 404 also requires our independent registered public accounting firm to attest to, and report on, management’s assessment of our internal control over financial reporting. See “Controls and Procedures.”
 
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be 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. Controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. Over time, controls may become inadequate because changes in conditions or deterioration in the degree of compliance with policies or procedures may occur. Because of the inherent limitations of a cost-effective control system, misstatements due to error or fraud may occur and not be detected.
 
We identified material weaknesses in our internal control over financial reporting for the year ended December 31, 2007 and we cannot assure you that significant deficiencies or material weaknesses in our internal control over financial reporting will not be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, or result in material misstatements in our financial statements. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding disclosure controls and the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder. The existence of a material weakness could result in errors in our financial statements that could result in a restatement of financial statements, cause us to fail to timely meet our reporting obligations and cause investors to lose confidence in our reported financial information, leading to a decline in our stock price.
 
Operational difficulties at our production facilities could negatively impact our sales volumes and could cause us to incur substantial losses.
 
Our operations are subject to labor disruptions, unscheduled downtimes and other operational hazards inherent in our industry, such as 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 our plants are designed to operate at or above a certain production capacity. The operation of our plants is and will be, however, subject to various uncertainties. As a result, our plants may not produce ethanol and its co-products at the levels we expect. In the event any of our plants do not run at their expected capacity levels, our business, results of operations and financial condition may be materially and adversely affected.
 
The United States ethanol industry is highly dependent upon a myriad of federal and state legislation and regulation and any changes in such legislation or regulation could have a material adverse effect on our results of operations and financial condition.
 
The elimination or reduction of federal excise tax incentives could have a material adverse effect on our results of operations and our financial condition.
 
The amount of ethanol production capacity in the U.S. exceeds the mandated usage of renewable biofuels. Ethanol consumption above mandated amounts is primarily based upon the economic benefit derived by blenders, including benefits received from federal excise tax incentives. Therefore, the production of ethanol is made significantly more competitive by federal tax incentives. The federal excise tax incentive program, which is scheduled to expire on December 31, 2010, allows gasoline distributors who blend ethanol with gasoline to receive a federal excise tax rate reduction for each blended gallon they sell regardless of the blend rate. The current federal excise tax on gasoline is $0.184 per gallon, and is paid at the terminal by refiners and marketers. If the fuel is blended with ethanol, the blender may claim a $0.45 per gallon tax credit for each gallon of ethanol used in the mixture. The 2008 Farm Bill enacted into law reduced federal excise tax incentives from $0.51 per gallon in 2008 to $0.45 per gallon in 2009. The federal excise tax incentive program may not be renewed prior to its expiration in 2010, or if renewed, it may be renewed on terms significantly less favorable than current tax incentives. The elimination or significant reduction in the federal excise tax incentive program could reduce discretionary blending and have a material adverse effect on our results of operations and our financial condition.
 
Various studies have criticized the efficiency of ethanol in general, and corn-based ethanol in particular, which could lead to the reduction or repeal of incentives and tariffs that promote the use and domestic production of ethanol or otherwise negatively impact public perception and acceptance of ethanol as an alternative fuel.
 
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 as potentially depleting water resources. Other studies have suggested that corn-based ethanol is less efficient than ethanol produced from switchgrass or wheat grain and that it negatively impacts consumers by causing higher prices for dairy, meat and other foodstuffs from livestock that consume corn. If these views gain acceptance, support for existing measures promoting the use and domestic production of corn-based ethanol could decline, leading to a reduction or repeal of these measures. These views could also negatively impact public perception of the ethanol industry and acceptance of ethanol as an alternative fuel.
 
Waivers or repeal of the national RFS minimum levels of renewable fuels included in gasoline could have a material adverse affect on our results of operations.
 
Shortly after passage of the Energy Independence and Security Act of 2007, which increased the minimum mandated required usage of ethanol, a Congressional sub-committee held hearings on the potential impact of the new national RFS on commodity prices. While no action was taken by the sub-committee towards repeal of the new national RFS, any attempt by Congress to re-visit, repeal or grant waivers of the new national RFS could adversely affect demand for ethanol and could have a material adverse effect on our results of operations and financial condition.
 
 
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While the Energy Independence and Security Act of 2007 imposes the national RFS, it does not mandate only the use of ethanol.
 
The Energy Independence and Security Act of 2007 imposes the national RFS, but does not mandate only the use of ethanol. While the RFA expects that ethanol should account for the largest share of renewable fuels produced and consumed under the national RFS, the national RFS is not limited to ethanol and also includes biodiesel and any other liquid fuel produced from biomass or biogas.
 
The ethanol production and marketing industry is extremely competitive. Many of our significant competitors have greater production and financial resources than we do and one or more of these competitors could use their greater resources to gain market share at our expense. In addition, certain of our suppliers may circumvent our marketing services, causing our sales and profitability to decline.
 
The ethanol production and marketing industry is extremely competitive. Many of our significant competitors in the ethanol production and marketing industry, such as ADM, Cargill, Inc., and other competitors have substantially greater production and/or financial resources than we do. As a result, our competitors may be able to compete more aggressively and sustain that competition over a longer period of time than we could. Successful competition will require a continued high level of investment in marketing and customer service and support. Our lack of resources relative to many of our 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 our 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 increasing competition from international suppliers. Currently, international suppliers produce ethanol primarily from sugar cane and have cost structures that are generally substantially lower than ours. 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 results of operations and financial condition.
 
In addition, some of our suppliers are potential competitors and, especially if the price of ethanol reaches historically high levels, they may seek to capture additional profits by circumventing our marketing services in favor of selling directly to our customers. If one or more of our major suppliers, or numerous smaller suppliers, circumvent our marketing services, our sales and profitability may decline.
 
The high concentration of our sales within the ethanol marketing and production industry could result in a significant reduction in sales and negatively affect our profitability if demand for ethanol declines.
 
We expect to be completely focused on the marketing and production of ethanol and its co-products for the foreseeable future. We may be unable to shift our business focus away from the marketing and production of ethanol to other renewable fuels or competing products. Accordingly, an industry shift away from ethanol or the emergence of new competing products may reduce the demand for ethanol. A downturn in the demand for ethanol would likely materially and adversely affect our sales and profitability.
 
 
-20-

 
We produce and sell our own ethanol but also depend on a small number of third-party suppliers for a significant portion of the ethanol that we sell. If any of these suppliers does not continue to supply us with ethanol in adequate amounts, we may be unable to satisfy the demands of our customers and our sales, profitability and relationships with our customers will be adversely affected.
 
We produce and sell our own ethanol but also depend on a small number of third-party suppliers for a significant portion of the ethanol that we sell. We expect to continue to depend for the foreseeable future upon a small number of third-party suppliers for a significant portion of the ethanol that we sell. Our third-party suppliers are primarily located in the Midwestern United States. The delivery of ethanol from these suppliers is therefore subject to delays resulting from inclement weather and other conditions. If any of these suppliers is unable or declines for any reason to continue to supply us with ethanol in adequate amounts, we may be unable to replace that supplier and source other supplies of ethanol in a timely manner, or at all, to satisfy the demands of our customers. If this occurs, our sales, profitability and our relationships with our customers will be adversely affected.
 
We may be adversely affected by environmental, health and safety laws, regulations and liabilities.
 
We are subject to various federal, state and local environmental laws and regulations, including those relating to the discharge of materials into the air, water and ground, the generation, storage, handling, use, transportation and disposal of hazardous materials, and the health and safety of our employees. In addition, some of these laws and regulations require our facilities to operate under permits that are subject to renewal or modification. These laws, regulations and permits can often require expensive pollution control equipment or operational changes to limit actual or potential impacts to the environment. A violation of these laws and regulations or permit conditions can result in substantial fines, natural resource damages, criminal sanctions, permit revocations and/or facility shutdowns. In addition, we have made, and expect to make, significant capital expenditures on an ongoing basis to comply with increasingly stringent environmental laws, regulations and permits.
 
We may be liable for the investigation and cleanup of environmental contamination at each of the properties that we own or operate and at off-site locations where we arrange for the disposal of hazardous substances. If these substances have been or are disposed of or released at sites that undergo investigation and/or remediation by regulatory agencies, we may be responsible under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, or other environmental laws for all or part of the costs of investigation and/or remediation, and for damages to natural resources. We may also be subject to related claims by private parties alleging property damage and personal injury due to exposure to hazardous or other materials at or from those properties. Some of these matters may require us to expend significant amounts for investigation, cleanup or other costs.
 
In addition, new laws, new interpretations of existing laws, increased governmental enforcement of environmental laws or other developments could require us to make significant additional expenditures. Continued government and public emphasis on environmental issues can be expected to result in increased future investments for environmental controls at our production facilities. Present and future environmental laws and regulations (and interpretations thereof) applicable to our operations, more vigorous enforcement policies and discovery of currently unknown conditions may require substantial expenditures that could have a material adverse effect on our results of operations and financial condition.
 
The hazards and risks associated with producing and transporting our products (such as fires, natural disasters, explosions and abnormal pressures and blowouts) may also result in personal injury claims or damage to property and third parties. As protection against operating hazards, we maintain insurance coverage against some, but not all, potential losses. However, we could sustain losses for uninsurable or uninsured risks, or in amounts in excess of existing insurance coverage. Events that result in significant personal injury or damage to our property or third parties or other losses that are not fully covered by insurance could have a material adverse effect on our results of operations and financial condition.
 
 
-21-

 
We depend on a small number of customers for the majority of our sales. A reduction in business from any of these customers could cause a significant decline in our overall sales and profitability.
 
The majority of our sales are generated from a small number of customers. During each of 2007 and 2008, sales to our two largest customers, each of whom accounted for 10% or more of total net sales, represented an aggregate of approximately 32% of our total net sales for those years. We expect that we will continue to depend for the foreseeable future upon a small number of customers for a significant portion of our sales. Our agreements with these customers generally do not require them to purchase any specified amount of ethanol or dollar amount of sales or to make any purchases whatsoever. Therefore, in any future period, our sales generated from these customers, individually or in the aggregate, may not equal or exceed historical levels. If sales to any of these customers cease or decline, we may be unable to replace these sales with sales to either existing or new customers in a timely manner, or at all. A cessation or reduction of sales to one or more of these customers could cause a significant decline in our overall sales and profitability.
 
Our lack of long-term ethanol orders and commitments by our customers could lead to a rapid decline in our sales and profitability.
 
We cannot rely on long-term ethanol orders or commitments by our customers for protection from the negative financial effects of a decline in the demand for ethanol or a decline in the demand for our marketing services. The limited certainty of ethanol orders can make it difficult for us to forecast our sales and allocate our resources in a manner consistent with our actual sales. Moreover, our expense levels are based in part on our expectations of future sales and, if our expectations regarding future sales are inaccurate, we may be unable to reduce costs in a timely manner to adjust for sales shortfalls. Furthermore, because we depend on a small number of customers for a significant portion of our sales, the magnitude of the ramifications of these risks is greater than if our sales were less concentrated. As a result of our lack of long-term ethanol orders and commitments, we may experience a rapid decline in our sales and profitability.
 
We are a minority member of Front Range with limited control over that entity’s business decisions. We are therefore dependent upon the business judgment and conduct of the manager and majority member of that entity. As a result, our interests may not be as well served as if we were in control of Front Range, which could adversely affect its contribution to our results of operations and our business prospects related to that entity.
 
Front Range operates an ethanol production facility located in Windsor, Colorado. We own approximately 42% of Front Range, which represents a minority interest in that entity. The manager and majority member of Front Range owns approximately 54% of that entity and has control of that entity’s business decisions, including those related to day-to-day operations. The manager and majority member of Front Range has the right to set the manager’s compensation, determine cash distributions, decide whether or not to expand the ethanol production facility and make most other business decisions on behalf of that entity. We are therefore largely dependent upon the business judgment and conduct of the manager and majority member of Front Range. As a result, our interests may not be as well served as if we were in control of Front Range. Accordingly, the contribution by Front Range to our results of operations and our business prospects related to that entity may be adversely affected by our lack of control over that entity.
 
 
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Risks Related to our Common Stock
 
Our common stock may be involuntarily delisted from trading on NASDAQ if we fail to maintain a minimum closing bid price of $1.00 per share for any consecutive 30 trading day period. A notification of delisting or a delisting of our common stock would reduce the liquidity of our common stock and inhibit or preclude our ability to raise additional financing and may also materially and adversely impact our credit terms with our vendors.
 
NASDAQ’s quantitative listing standards require, among other things, that listed companies maintain a minimum closing bid price of $1.00 per share. However, NASDAQ has recently suspended its minimum closing bid price threshold through July 19, 2009. If, upon reinstatement of the minimum closing bid price threshold, we fail to satisfy this threshold for any consecutive 30 trading day period, our common stock may be involuntarily delisted from trading on NASDAQ once the applicable grace period expires. Our stock price has remained below $1.00 since early November 2008. Given the increased market volatility arising in part from economic turmoil resulting from the ongoing credit crisis, as well as a challenging environment in the biofuels industry, the closing bid price of our common stock could be below $1.00 per share for a consecutive 30 trading day period after the NASDAQ reinstates its rules. A notification of delisting or delisting of our common stock would reduce the liquidity of our common stock and inhibit or preclude our ability to raise additional financing and may also materially and adversely impact our credit terms with our vendors.
 
As a result of our issuance of shares of Series B Preferred Stock, our common stockholders may experience numerous negative effects and most of the rights of our common stockholders will be subordinate to the rights of the holders of our Series B Preferred Stock.
 
As a result of our issuance of shares of Series B Preferred Stock, our common stockholders may experience numerous negative effects, including dilution from any dividends paid in preferred stock and certain antidilution adjustments. In addition, rights in favor of the holders of our Series B Preferred Stock include: seniority in liquidation and dividend preferences; substantial voting rights; numerous protective provisions; and preemptive rights. Also, our outstanding Series B Preferred Stock could have the effect of delaying, deferring and discouraging another party from acquiring control of Pacific Ethanol.
 
Our stock price is highly volatile, which could result in substantial losses for investors purchasing shares of our common stock and in litigation against us.
 
The market price of our common stock has fluctuated significantly in the past and may continue to fluctuate significantly in the future. The market price of our common stock may continue to fluctuate in response to one or more of the following factors, many of which are beyond our control:

changing conditions in the ethanol and fuel markets as well as other commodity markets such as corn;
the volume and timing of the receipt of orders for ethanol from major customers;
competitive pricing pressures;
our ability to produce, sell and deliver ethanol on a cost-effective and timely basis;
the introduction and announcement of one or more new alternatives to ethanol by our competitors;
changes in market valuations of similar companies;
stock market price and volume fluctuations generally;
our stock’s relative small public float;
regulatory developments or increased enforcement;
fluctuations in our quarterly or annual operating results;
additions or departures of key personnel;
our inability to obtain construction, acquisition, capital equipment and/or working capital financing; and
future sales of our common stock or other securities.
 
 
-23-

 
Furthermore, we believe that the economic conditions in California and other Western states, as well as the United States as a whole, could have a negative impact on our results of operations. Demand for ethanol could also be adversely affected by a slow-down in overall demand for oxygenate and gasoline additive products. The levels of our ethanol production and purchases for resale will be based upon forecasted demand. Accordingly, any inaccuracy in forecasting anticipated revenues and expenses could adversely affect our business. The failure to receive anticipated orders or to complete delivery in any quarterly period could adversely affect our results of operations for that period. Quarterly results are not necessarily indicative of future performance for any particular period, and we may not experience revenue growth or profitability on a quarterly or an annual basis.
 
The price at which you purchase shares of our common stock may not be indicative of the price that will prevail in the trading market. You may be unable to sell your shares of common stock at or above your purchase price, which may result in substantial losses to you and which may include the complete loss of your investment. In the past, securities class action litigation has often been brought against a company following periods of stock price volatility. We may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert management’s attention and our resources away from our business.
 
Any of the risks described above could have a material adverse effect on our sales and profitability and the price of our common stock.
 
Unresolved Staff Comments.
 
None.
 
Item 2.
Properties.
 
Our corporate headquarters, located in Sacramento, California, consists of a leased 10,000 square foot office expiring in 2010. We also rent an office in Portland, Oregon, consisting of 3,500 square feet, expiring in 2012.
 
Our ethanol production facilities are located in Madera, California, at which a 137 acre facility is located, Boardman, Oregon, at which a 25 acre facility is located, Burley, Idaho, at which a 160 acre facility is located, Stockton, California, at which a 30 acre facility is located and Windsor, Colorado, at which a 40 acre facility is located. We are a minority owner of the entity that owns the Windsor, Colorado facility. Further, we have options to acquire sites for other potential ethanol production facilities that we may develop in the future. See “Business—Production Facilities.”
 
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 materially and adversely affect our financial position, results of operations or cash flows.
 
 
-24-

 
Western Ethanol Company
 
On January 9, 2009, Western Ethanol Company, LLC (“Western Ethanol”) filed a complaint in the Superior Court of the State of California (the “Superior Court”) naming Kinergy as defendant. In the complaint, Western Ethanol alleges that Kinergy breached an alleged agreement to buy and accept delivery of a fixed amount of ethanol. On January 12, 2009, Western Ethanol filed an application for issuance of right to attach order and order for issuance of writ of attachment. On February 10, 2009, the Superior Court granted the right to attach order and order for issuance of writ of attachment against Kinergy in the amount of approximately $3.7 million. On February 11, 2009, Kinergy filed an answer to the complaint. Kinergy intends to vigorously defend against Western Ethanol’s claims.
 
Delta-T Corporation
 
On August 18, 2008, Delta-T Corporation filed suit in the United States District Court for the Eastern District of Virginia (the “Virginia Federal Court case”), naming Pacific Ethanol, Inc. as a defendant, along with its subsidiaries Pacific Ethanol Stockton, LLC, Pacific Ethanol Imperial, LLC, Pacific Ethanol Columbia, LLC, Pacific Ethanol Magic Valley, LLC and Pacific Ethanol Madera, LLC. The suit alleges breaches of the parties’ Engineering, Procurement and Technology License Agreements, breaches of a subsequent term sheet and letter agreement and breaches of indemnity obligations. 
 
All of the defendants have moved to dismiss the Virginia Federal Court Case for lack of personal jurisdiction and on the ground that all disputes between the parties must be resolved through binding arbitration, and, in the alternative, moving to stay the Virginia Federal Court Case pending arbitration. In January 2009, these motions were granted by the Court, compelling the case to arbitration. The complaint seeks specified contract damages of approximately $6.5 million, along with other unspecified damages. We intend to vigorously defend against Delta-T Corporation’s claims.
 
Barry Spiegel – State Court Action
 
On December 23, 2005, Barry J. Spiegel, a former shareholder and director of Accessity, filed a complaint in the Circuit Court of the 17th Judicial District in and for Broward County, Florida (Case No. 05018512) (the “State Court Action”) against Barry Siegel, Philip Kart, Kenneth Friedman and Bruce Udell (collectively, the “Individual Defendants”). Messrs. Siegel, Udell and Friedman are former directors of Accessity and Pacific Ethanol. Mr. Kart is a former executive officer of Accessity and Pacific Ethanol.
 
The State Court Action relates to the Share Exchange Transaction and purports to state the following five counts against the Individual Defendants: (i) breach of fiduciary duty, (ii) violation of the Florida Deceptive and Unfair Trade Practices Act, (iii) conspiracy to defraud, (iv) fraud, and (v) violation of Florida’s Securities and Investor Protection Act. Mr. Spiegel based his claims on allegations that the actions of the Individual Defendants in approving the Share Exchange Transaction caused the value of his Accessity common stock to diminish and is seeking approximately $22.0 million in damages. On March 8, 2006, the Individual Defendants filed a motion to dismiss the State Court Action. Mr. Spiegel filed his response in opposition on May 30, 2006. The Court granted the motion to dismiss by Order dated December 1, 2006, on the grounds that, among other things, Mr. Spiegel failed to bring his claims as a derivative action.
 
On February 9, 2007, Mr. Spiegel filed an amended complaint which purports to state the following five counts: (i) breach of fiduciary duty, (ii) fraudulent inducement, (iii) violation of Florida’s Securities and Investor Protection Act, (iv) fraudulent concealment, and (v) breach of fiduciary duty of disclosure. The amended complaint included Pacific Ethanol as a defendant, but it was subsequently voluntarily dismissed on August 27, 2007, by Mr. Spiegel as to Pacific Ethanol. On March 23, 2009, Mr. Spiegel filed an amended complaint which renewed his previously voluntarily dismissed case against Pacific Ethanol.  Further Mr. Spiegel seeks depositions of Barry Siegel and Philip B. Kart on or around April 30, 2009. We intend to vigorously defend against Mr. Spiegel’s claims.
 
 
-25-

 
Barry Spiegel – Federal Court Action
 
On December 28, 2006, Barry J. Spiegel, filed a complaint in the United States District Court, Southern District of Florida (Case No. 06-61848) (the “Federal Court Action”) against the Individual Defendants and Pacific Ethanol. The Federal Court Action relates to the Share Exchange Transaction and purports to state the following three counts: (i) violations of Section 14(a) of the Exchange Act and SEC Rule 14a-9 promulgated thereunder, (ii) violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and (iii) violation of Section 20(A) of the Exchange Act. The first two counts are alleged against the Individual Defendants and Pacific Ethanol and the third count is alleged solely against the Individual Defendants. Mr. Spiegel bases his claims on, among other things, allegations that the actions of the Individual Defendants and Pacific Ethanol in connection with the Share Exchange Transaction resulted in a share exchange ratio that was unfair and resulted in the preparation of a proxy statement seeking shareholder approval of the Share Exchange Transaction that contained material misrepresentations and omissions. Mr. Spiegel is seeking in excess of $15.0 million in damages.
 
Mr. Spiegel amended the Federal Court Action on March 5, 2007, and Pacific Ethanol and the Individual Defendants filed a Motion to Dismiss the amended pleading on April 23, 2007. Plaintiff Spiegel sought to stay his own federal case, but the Motion was denied on July 17, 2007. The Court required Mr. Spiegel to respond to our Motion to Dismiss. On January 15, 2008, the Court rendered an Order dismissing the claims under Section 14(a) of the Exchange Act on the basis that they were time barred and that more facts were needed for the claims under Section 10(b) of the Exchange Act. The Court, however, stayed the entire case pending resolution of the State Court Action.
 
Submission of Matters to a Vote of Security Holders.
 
None.
 
 
-26-

 
PART II
 
Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
 
Market Information
 
Our common stock has been traded on the Nasdaq Global Market (formerly, the Nasdaq National Market) under the symbol “PEIX” since October 10, 2005. Prior to October 10, 2005 and since March 24, 2005, our common stock traded on the Nasdaq Capital Market (formerly, the Nasdaq SmallCap Market) under the symbol “PEIX.” Prior to March 24, 2005, our common stock traded on the Nasdaq SmallCap Market under the symbol “ACTY.” The table below shows, for each fiscal quarter indicated, the high and low closing prices for shares of our common stock. This information has been obtained from The Nasdaq Stock Market. The prices shown reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions.

   
Price Range
 
   
High
   
Low
 
             
Year Ended December 31, 2008:
           
First Quarter (January 1 – March 31)
  $ 8.85     $ 4.25  
Second Quarter (April 1 – June 30)
  $ 5.65     $ 1.81  
Third Quarter (July 1 – September 30)
  $ 2.37     $ 1.37  
Fourth Quarter (October 1 – December 31)
  $ 1.41     $ 0.36  
                 
Year Ended December 31, 2007:
               
First Quarter
  $ 17.85     $ 14.22  
Second Quarter
  $ 16.50     $ 12.25  
Third Quarter
  $ 14.86     $ 8.58  
Fourth Quarter
  $ 9.46     $ 4.22  
 
Security Holders
 
As of March 26, 2009, we had 57,750,319 shares of common stock outstanding and held of record by approximately 500 stockholders. These holders of record include depositories that hold shares of stock for brokerage firms which, in turn, hold shares of stock for numerous beneficial owners. On March 26, 2009, the closing sale price of our common stock on the Nasdaq Global Market was $0.38 per share.
 
Performance Graph
 
The graph below shows a comparison of the cumulative total stockholder return on our common stock with the cumulative total return on The NASDAQ Stock Market (U.S.) Index and of public companies filing reports with the Securities and Exchange Commission under Standard Industrial Classification Code 2860—Industrial Organic Chemicals, or Peer Group, in each case over the five-year period ended December 31, 2008.
 
The graph includes the date of March 23, 2005, the date of the Share Exchange Transaction and the date on which we effectively began operating in a business properly categorized under Standard Industrial Classification Code 2860—Industrial Organic Chemicals. Our predecessor, Accessity, was in an unrelated business prior to March 23, 2005. See “Business—Company History.”
 
 
-27-

 
The graph assumes $100 invested at the indicated starting date in our common stock and in each of The NASDAQ Stock Market (U.S.) Index and the Peer Group, with the reinvestment of all dividends. We have not paid or declared any cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Stockholder returns over the indicated periods should not be considered indicative of future stock prices or stockholder returns. This graph assumes that the value of the investment in our common stock and each of the comparison groups was $100 on December 31, 2002.
 
Comparison of Cumulative Total Return
 
 
Cumulative Total Return ($)
 
12/03
12/04
3/23/05
12/05
12/06
12/07
12/08
PACIFIC ETHANOL, INC.
100.00
252.34
385.11
460.43
654.89
349.36
18.72
THE NASDAQ STOCK MARKET (U.S.) INDEX
100.00
110.08
104.15
112.88
126.51
138.13
80.47
SIC 2860—INDUSTRIAL ORGANIC CHEMICALS
100.00
126.07
118.68
105.11
152.61
122.81
52.96
 
Dividend Policy
 
We have never paid cash dividends on our common stock and do not intend to pay cash dividends on our common stock in the foreseeable future. We anticipate that we will retain any earnings for use in the continued development of our business.
 
Our current and future debt financing arrangements may limit or prevent cash distributions from our subsidiaries to us, depending upon the achievement of certain financial and other operating conditions and our ability to properly service the debt, thereby limiting or preventing us from paying cash dividends. In addition, the holders of our outstanding preferred stock are entitled to dividends of 7%, and those dividends must be paid prior to the payment of any dividends to our common stockholders.
 
Recent Sales of Unregistered Securities
 
None.
 
 
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Purchases of Equity Securities by the Issuer and Affiliated Purchasers
 
We have granted to certain employees and directors shares of restricted stock under our 2006 Stock Incentive Plan pursuant to Restricted Stock Agreements dated and effective as of their respective grant dates by and between us and those employees and directors.
 
We were obligated to withhold minimum withholding tax amounts with respect to vested shares of restricted stock and upon future vesting of shares of restricted stock granted to our employees. Each employee was entitled to pay the minimum withholding tax amounts to us in cash or to elect to have us withhold a vested amount of shares of restricted stock having a value equivalent to our minimum withholding tax requirements, thereby reducing the number of shares of vested restricted stock that the employee ultimately receives. If an employee failed to timely make such election, we automatically withheld the necessary shares of vested restricted stock.
 
In connection with satisfying our withholding requirements, during the month of October 2008, we withheld an aggregate of 21,249 shares of our common stock and remitted a cash payment to cover the minimum withholding tax amounts, thereby effectively repurchasing from the employees the 21,249 shares of common stock at a deemed purchase price equal to $1.28 per share for an aggregate purchase price of $27,199.
 
In connection with satisfying our withholding requirements, during the month of December 2008, we withheld an aggregate of 7,045 shares of our common stock and remitted a cash payment to cover the minimum withholding tax amounts, thereby effectively repurchasing from the employees the 7,045 shares of common stock at a deemed purchase price equal to $0.55 per share for an aggregate purchase price of $3,875.
 
-29-

 
Selected Financial Data.
 
The following financial information should be read in conjunction with the consolidated audited financial statements and the notes to those statements beginning on page F-1 of this report, and the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report. The consolidated statements of operations data for the years ended December 31, 2008, 2007 and 2006 and the consolidated balance sheet data at December 31, 2008 and 2007 are derived from, and are qualified in their entirety by reference to, the consolidated audited financial statements beginning on page F-1 of this report. The consolidated statements of operations data from January 1, 2004 to December 31, 2005 and the consolidated balance sheet data at December 31, 2004 are derived from, and qualified in their entirety by reference to, the consolidated audited financial statements of Pacific Ethanol. The historical results that appear below are not necessarily indicative of results to be expected for any future periods.
 
   
  Years Ended December 31,
 
     
2008 
     
2007
     
2006
     
2005
     
2004
 
     
(in thousands, except per share data)
 
Consolidated Statements of Operations Data:
                                       
Net sales
  $ 703,926     $ 461,513     $ 226,356     $ 87,599     $ 20  
Cost of goods sold
    737,331       428,614       201,527       84,444       13  
Gross profit (loss)
    (33,405 )     32,899       24,829       3,155       7  
Selling, general and administrative expenses
    31,796       30,822       24,641       12,638       2,277  
Impairment of goodwill
    87,047       -       -       -       -  
Impairment of asset group
    40,900       -       -       -       -  
Income (loss) from operations
    (193,148 )     2,077       188       (9,483 )     (2,270 )
Other income (expense), net
    (6,068 )     (6,801 )     3,426       (440 )     (532 )
Income (loss) before noncontrolling interest in variable interest entity and provision for income taxes
    (199,216 )     (4,724 )     3,614       (9,923 )     (2,802 )
Noncontrolling interest in variable interest entity
    52,669       (9,676 )     (3,756     -       -  
Loss before provision for income taxes
    (146,547 )     (14,400 )     (142     (9,923 )     (2,802
Provision for income taxes
    -       -       -       -       -  
Net loss
  $ (146,547 )   $ (14,400 )   $ (142 )   $ (9,923 )   $ (2,802 )
                                         
Preferred stock dividends
  $ (4,104 )   $ (4,200 )   $ (2,998 )   $ -     $ -  
Deemed dividend on preferred stock
    (761 )     (28 )     (84,000 )     -       -  
Loss available to common stockholders
  $ (151,412 )   $ (18,628 )   $ (87,140 )   $ (9,923 )   $ (2,802 )
Loss per share, basic and diluted
  $ (3.02 )   $ (0.47 )   $ (2.50   $ (0.40 )     $ (0.23 )
Weighted-average shares outstanding, basic and diluted
    50,147       39,895       34,855       25,066       12,397  
Consolidated Balance Sheet Data:
                                       
Cash and cash equivalents
  $ 11,466     $ 5,707     $ 44,053     $ 4,521     $ -  
Working capital (deficit)
  $ (288,313 )   $ (37,886 )   $ 96,094     $ (2,894 )   $ (1,025 )
Total assets
  $ 616,834     $ 651,600     $ 453,820     $ 48,185     $ 7,179  
Long-term debt
  $ 937     $ 151,188     $ 28,970     $ 1,995     $ 4,013  
Stockholders’ equity
  $ 209,373     $ 282,286     $ 298,445     $ 28,516     $ 1,356  
 
No cash dividends on our common stock were declared during any of the periods presented above.  Various factors materially affect the comparability of the information presented in the above table. These factors relate primarily to a Share Exchange Transaction that was consummated on March 23, 2005 with the shareholders of PEI California, and the holders of the membership interests of each of Kinergy and ReEnergy, pursuant to which we acquired all of the issued and outstanding capital stock of PEI California and all of the outstanding membership interests of Kinergy and ReEnergy. See “Business—Company History.” In addition, we acquired a minority interest in Front Range on October 17, 2006, at which date we began treating Front Range, a variable interest entity, as a consolidated subsidiary, as we are considered the primary beneficiary.
 
 
-30-

 
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, without limitation:

●  
fluctuations in the market price of ethanol and its co-products;
●  
the projected growth or contraction in the ethanol and co-product market in which we operate;
●  
our strategies for expanding, maintaining or contracting our presence in these markets;
●  
our ability to successfully develop, finance, construct and operate our current and any future ethanol production facilities;
●  
anticipated trends in our financial condition and results of operations; and
●  
our ability to distinguish ourselves from our current and future competitors.
 
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 in the “Risk Factors” section above 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.
 
Recent Developments
 
As a result of ethanol industry conditions that have negatively affected our business, we do not currently have sufficient liquidity to meet our anticipated working capital, debt service and other liquidity needs in the very near-term. We believe that we have sufficient working capital to continue operations only until approximately April 30, 2009 at the latest unless we successfully restructure our debt, experience a significant improvement in margins and obtain other sources of liquidity. In addition, although various secured creditors are presently forbearing through April 30, 2009 under outstanding forbearance agreements from exercising their rights, once those forbearance periods expire or in the event of additional defaults, we will be in default to those secured creditors who collectively hold security interests in substantially all of our assets. As a result, our 2008 financial statements include an explanatory paragraph by our independent registered public accounting firm describing the substantial doubt as to our ability to continue as a going concern.
 
As of March 26, 2009, we owed approximately $246.5 million in term loans and lines of credit associated with the construction and operation of our ethanol plants and approximately $5.3 million under our revolving credit facility. As of that date, we had only $4.0 million in cash and $4.7 million of additional borrowing availability under our revolving credit facility. As we continue to reduce the number of gallons of ethanol we sell and hold in inventory, working capital available to support borrowings under our revolving credit facility will reduce proportionately.
 
We do not expect to have sufficient liquidity to meet anticipated working capital, debt service and other liquidity needs beyond April 30, 2009 at the latest unless we successfully restructure our debt, experience a significant improvement in margins and obtain other sources of liquidity. Based on the current spread between corn and ethanol prices, the industry is operating at or near break-even cash margins. The current spread between ethanol and corn prices cannot support the long-term viability of the U.S. ethanol industry in general or us in particular.
 
 
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Although we are actively pursuing a number of alternatives, including seeking to restructure our debt and seeking to raise additional debt or equity financing, or both, there can be no assurance that we will be successful. If we cannot restructure our debt and obtain sufficient liquidity in the very near term, we may need to seek protection under the U.S. Bankruptcy Code.
 
Business Overview
 
Our primary goal is to be the leading marketer and producer of low carbon renewable fuels in the Western United States.
 
We produce and sell ethanol and its co-products, including wet distillers grain, or WDG, and provide transportation, storage and delivery of ethanol through third-party service providers in the Western United States, primarily in California, Nevada, Arizona, Oregon, Colorado, Idaho and Washington. We have extensive customer relationships throughout the Western United States and extensive supplier relationships throughout the Western and Midwestern United States.
 
In September 2008, we completed construction of our fourth ethanol plant. Our four ethanol plants, which produce ethanol and its co-products, are as follows:
 
     
Estimated Annual
   
Date Operations
Production Capacity
Facility Name
Facility Location
Began
(gallons)
Stockton
Stockton, CA
September 2008
60,000,000
Magic Valley
Burley, ID
April 2008
60,000,000
Columbia
Boardman, OR
September 2007
40,000,000
Madera
Madera, CA
October 2006
40,000,000
 
In addition, we own a 42% interest in Front Range, which owns a plant located in Windsor, Colorado, with annual production capacity of up to 50 million gallons. We also intend to either construct or acquire additional production facilities as financial resources and business prospects make the construction or acquisition of these facilities advisable.
 
According to the United States Department of Energy, or DOE, total annual gasoline consumption in the United States is approximately 140 billion gallons. Total annual ethanol consumption represented less than 7% of this amount in 2008. We believe that the domestic ethanol industry has substantial potential for growth to initially reach what we estimate is an achievable level of at least 10% of the total annual gasoline consumption in the United States, or approximately 14 billion gallons of ethanol annually and thereafter up to 36 billion gallons of ethanol annually under the new national Renewable Fuel Standards, or RFS, by 2022. See “Business—Governmental Regulation.”
 
The ethanol industry has experienced significant adverse conditions over the course of the last 12 months, including prolonged negative operating margins. We, too, have experienced these adverse conditions as well as severe working capital and liquidity shortages, and in response to such conditions, we have reduced production significantly until market conditions resume to acceptable levels and working capital becomes available. We first reduced production in December 2008 and continued to reduce production through the first quarter of 2009. Currently, we have ceased production at our Madera, Magic Valley and Stockton facilities. We continue to operate our Columbia and Front Range facilities. We continue to assess market conditions and when appropriate, provided we have adequate available working capital, we plan to bring these facilities back to operation.
 
 
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We intend to reach our goal to be the leading marketer and producer of low carbon renewable fuels in the Western United States in part by expanding our relationships with customers and third-party ethanol producers to market higher volumes of ethanol, by expanding our relationships with animal feed distributors and end users to build local markets for WDG, the primary co-product of our ethanol production, and by expanding the market for ethanol by continuing to work with state governments to encourage the adoption of policies and standards that promote ethanol as a fuel additive and transportation fuel.
 
Financial Performance Summary
 
Our net sales increased by $242.4 million, or 53%, to $703.9 million for the year ended December 31, 2008 from $461.5 million for the year ended December 31, 2007. Our net loss, however, increased by $132.1 million to $146.5 million for the year ended December 31, 2008 from $14.4 million for the year ended December 31, 2007.
 
Factors that contributed to our results of operations for 2008 include:
 
 
Net sales. The increase in our net sales in 2008 as compared to 2007 was primarily due to the following combination of factors:
 
o  
Higher sales volumes. Total volume of ethanol sold increased by 41% to 268.4 million gallons in 2008 from 190.6 million gallons in 2007. The increase in sales volume is primarily due to two additional ethanol production facilities that commenced operations in 2008. Sales also increased in 2008 from additional supply purchased from third-party suppliers under our ethanol marketing agreements; and
 
o  
Higher ethanol prices. The increase in sales volume was also due to slightly higher ethanol prices. Our average sales price of ethanol increased 5% to $2.25 per gallon in 2008 as compared to $2.15 per gallon in 2007.
 
 
Gross margins. Our gross margins decreased significantly to negative 4.7% for 2008 as compared to a gross profit margin of 7.1% for 2007. This drop in gross profit margins was primarily due to higher corn prices and was exacerbated by significant volatility in the corn market during 2008. Volatility and the time from purchase of the corn to sale of the resulting ethanol created significant losses during 2008. The average price of corn increased by 53% to $5.52 per bushel in 2008 from $3.61 per bushel in 2007. The average Chicago Board of Trade, or CBOT, price for corn increased by 41% to $5.27 per bushel in 2008 from $3.74 per bushel in 2007.
 
 
Selling, general and administrative expenses. Our selling, general and administrative expenses increased by $1.0 million to $31.8 million in 2008 as compared to $30.8 million in 2007 primarily as a result of increases in administrative staff, bad debt expenses, derivatives commissions and noncash compensation expenses, partially offset by decreases in professional fees and amortization of intangible assets. Although these expenses increased in absolute dollars, they decreased to 4.5% of our net sales in 2008 as compared to 6.6% of our net sales in 2007 due to the substantial growth in our net sales over those periods.
 
 
Impairments of goodwill and asset group. In 2008, we recognized $87.0 million in impairment of goodwill and $40.9 million in impairment of asset group. The impairment of goodwill related to our annual goodwill review, mostly reflecting a decline in the valuation of our prior purchase of our 42% interest in Front Range. The impairment of asset group reflects our decision to abandon construction of our Imperial Valley ethanol production facility due to adverse market conditions.
 
 
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Other expense. Our other expense decreased by $0.7 million to $6.1 million in 2008 from $6.8 million in 2007. This decrease is primarily due to increased sales of our business energy tax credits, decreased mark-to-market losses and decreased finance cost amortization, which were partially offset by an increase in interest expense, decreased interest income and increased bank fees.
 
Sales and Margins
 
Over the past three years, our sales mix has shifted significantly from sales generated solely as a marketer of ethanol produced by third parties to now include sales generated as a producer of our own ethanol. Our cost structure also changed significantly, beginning in 2007, as our Madera and Front Range facilities were in full production and continuing in 2008 as our Columbia facility was in full production and our Magic Valley and Stockton facilities commenced operations. The shift in our sales mix greatly altered our dependency on certain market conditions from that based primarily on the market price of ethanol to that based significantly on the cost of corn, the principal input commodity for our production of ethanol. Accordingly, our profitability is now highly dependent on the market price of ethanol and the cost of corn.
 
Average ethanol sales prices rose in 2008 as compared to 2007. Specifically, the average CBOT price of ethanol increased by 12% in 2008 as compared to 2007. The increase in the prevailing market price of ethanol was primarily due to the rise of crude oil during the middle of 2008.
 
Average corn prices increased significantly in 2008 as compared to 2007. Specifically, the average CBOT price of corn increased by 41% in 2008 as compared to 2007. The increase in the prevailing market price of corn was the primary cause of the increase in our average corn price. More importantly, corn prices experienced significant volatility in a relatively short period of time during 2008. The average CBOT price of corn increased from $5.99 at the end of May 2008 to a record high of $7.55 on June 27, 2008 and then decreased to $5.88 at the end of July 2008. Since we now produce more of the ethanol that we sell and there is a time lag from the time we price and purchase our corn to the actual sale of resultant ethanol to a customer, this volatility created significant negative margins for us in 2008.
 
We have three principal methods of selling ethanol: as a merchant, as a producer and as an agent. See “Critical Accounting Policies—Revenue Recognition” below.
 
When acting as a merchant or as a producer, we generally enter into sales contracts to ship ethanol to a customer’s desired location. We support these sales contracts through purchase contracts with several third-party suppliers or through our own production. We manage the necessary logistics to deliver ethanol to our customers either directly from a third-party supplier or from our inventory via truck or rail. Our sales as a merchant or as a producer expose us to price risks resulting from potential fluctuations in the market price of ethanol and corn. Our exposure varies depending on the magnitude of our sales and purchase commitments compared to the magnitude of our existing inventory, as well as the pricing terms—such as market index or fixed pricing—of our contracts. We seek to mitigate our exposure to price risks by implementing appropriate risk management strategies.
 
When acting as an agent for third-party suppliers, we conduct back-to-back purchases and sales in which we match ethanol purchase and sale contracts of like quantities and delivery periods. When acting as an agent for third-party suppliers, we receive a predetermined service fee and we have little or no exposure to price risks resulting from potential fluctuations in the market price of ethanol.
 
 
-34-

 
We believe that our gross profit margins will primarily depend on five key factors:
 
  
the market price of ethanol, which we believe will be impacted by the degree of competition in the ethanol market, the price of gasoline and related petroleum products, and government regulation, including tax incentives;
 
  
the market price of key production input commodities, including corn and natural gas;
 
  
the market price of WDG;
 
  
our ability to anticipate trends in the market price of ethanol, WDG, and key input commodities and implement appropriate risk management and opportunistic strategies; and
 
  
the proportion of our sales of ethanol produced at our facilities to our sales of ethanol produced by third-parties.
 
Management seeks to optimize our gross profit margins by anticipating the factors above and, when resources are available, implementing hedging transactions and taking other actions designed to limit risk and address the various factors. For example, we may seek to decrease inventory levels in anticipation of declining ethanol prices and increase inventory levels in anticipation of increasing ethanol prices. We may also seek to alter our proportion or timing, or both, of purchase and sales commitments.
 
Our limited resources to act upon anticipated factors above and/or our inability to anticipate these factors or their relative importance, and adverse movements in the factors themselves, could result in declining or even negative gross profit margins over certain periods of time. Our ability to anticipate those factors or favorable movements in the factors themselves may enable us to generate above-average gross profit margins. However, given the difficulty associated with successfully forecasting any of these factors, we are unable to estimate our future gross profit margins.
 
Results of Operations
 
The following selected financial data 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:
   
  Years Ended December 31,
     
Percentage Variance
From Prior Year
     
2008 
     
2007
     
2006 
     
2008 
   
2007
Gallons sold (in millions)
    268.4       190.6       101.7       40.8 %     87.4 %
Average sales price per gallon
  $ 2.25     $ 2.15     $ 2.28       4.7 %     (5.7 )%
Corn cost per bushel—CBOT equivalent(1)
  $ 5.52     $ 3.61     $ 2.44       52.9 %     48.0 %
Co-product revenues as % of delivered cost of corn(2)
    22.5 %     24.8 %     33.4 %     (9.3 )%     (25.7 )%
                                         
Average CBOT ethanol price per gallon
  $ 2.22     $ 1.98     $ 2.52       12.1 %     (21.4 )%
Average CBOT corn price per bushel
  $ 5.27     $ 3.74     $ 2.60       40.9 %     43.9 %
_____________
                                       
 
(1)
We exclude transportation—or “basis”—costs in our corn costs to calculate a CBOT equivalent in order to more appropriately compare our corn costs to average CBOT corn prices.
 
(2)
Co-product revenues as % of delivered cost of corn shows our yield based on sales of WDG generated from ethanol we produced.
 
 
-35-

 
Year Ended December 31, 2008 Compared to the Year Ended December 31, 2007
 
                             
Results as a Percentage
               
Dollar
     
Percentage
   
of Net Sales for the
   
Years Ended
   
Variance
     
Variance
   
Years Ended
   
December 31,
   
Favorable
     
Favorable
   
December 31,
   
2008
   
2007
   
(Unfavorable)
     
(Unfavorable)
   
2008
   
2007
   
(dollars in thousands)
Net sales
 
$
703,926     $ 461,513     $ 242,413       52.5 %       100.0 %       100.0 %
Cost of goods sold
    737,331       428,614       (308,717 )     (72.0 )       104.7         92.9  
Gross profit (loss)
    (33,405 )     32,899       (66,304 )     (201.5 )       (4.7 )       7.1  
Selling, general and administrative expenses
    31,796       30,822       (974 )     (3.2 )       4.5         6.6  
Impairment of goodwill
    87,047             (87,047 )    
NM
        12.4          
Impairment of asset group
    40,900             (40,900 )    
NM
 
      5.8          
Income (loss) from operations
    (193,148 )     2,077       (195,225 )    
NM
        (27.4 )       0.5  
Other income (expense), net
    (6,068 )     (6,801 )     733       10.8         (0.9 )       (1.5 )
Loss before noncontrolling interest in variable interest entity and provision for income taxes
    (199,216 )     (4,724 )     (194,492 )    
NM
        (28.3 )       (1.0 )
Noncontrolling interest in variable interest entity
    52,669       (9,676 )     (62,345 )     (644.3 )       7.5         (2.1 )
Loss before provision for income taxes
    (146,547 )     (14,400 )     (132,147 )     (917.7 )       (20.8 )       (3.1 )
Provision for income taxes
                                       
Net loss
  $ (146,547 )   $ (14,400 )   $ (132,147 )     (917.7 )%       (20.8 )%       (3.1 )%
Preferred stock dividends
  $ (4,104 )   $ (4,200 )   $ 96       2.3 %       (0.6 )%       (0.9 )%
Deemed dividend on preferred stock
    (761 )     (28 )     (733 )    
NM
        (0.1 )       (0.0 )
Loss available to common stockholders
  $ (151,412 )   $ (18,628 )   $ (132,784 )     (712.8 )%       (21.5 )%       (4.0 )%
 
Net Sales
 
The increase in our net sales in 2008 as compared to 2007 was primarily due to a substantial increase in sales volume, coupled with higher average sales prices.
 
Total volume of ethanol sold increased by 77.8 million gallons, or 41%, to 268.4 million gallons in 2008 as compared to 190.6 million gallons in 2007. The substantial increase in sales volume is primarily due to production at all four of our facilities, two of which were completed in 2008, as well as increased sales volume from our third-party ethanol marketing agreements. During 2008, we completed construction of our Stockton and Magic Valley facilities and in 2007, we completed construction of our Columbia facility. Our Madera facility has been in operation since October 2006. The increased amount of sales from our Columbia, Magic Valley and Stockton facilities contributed $182.9 million to the increase in our net sales for 2008.
 
Our average sales price per gallon increased 5% to $2.25 in 2008 from an average sales price per gallon of $2.15 in 2007. The average CBOT price per gallon increased 12% to $2.22 in 2008 from an average CBOT price per gallon of $1.98 in 2007. Our average sales price per gallon did not increase as much as the average CBOT price per gallon for 2008 due to both the timing of our sales and the proportion of our fixed-price contracts during a period of rising ethanol prices.
 
Cost of Goods Sold and Gross Profit (Loss)
 
Our gross margin declined to a negative $33.4 million for 2008 from a positive $32.9 million for 2007 due to higher corn costs. Corn is the single largest component of the cost of our ethanol production and has become a larger portion of our cost of goods sold as we have significantly increased our ethanol production.
 
Overall, the price of corn had a much larger impact on our production costs due to the timing of the corn and the related ethanol pricing from the time we purchase corn to the sale of ethanol. Generally, we fix our corn price upon shipment from the vendor, and in a falling market, our margins are compressed as both corn and ethanol prices continue to fall from transit to processing of the corn. Further, during 2008 we experienced unprecedented volatility in the price of corn ranging from the CBOT low for the year of $2.94 to the CBOT high for the year of $7.55. These prices moved in such a short period of time that it became difficult to sell the related ethanol production before the prices of both corn and ethanol changed dramatically- primarily downward-from the time of the corn purchase. Further, due to falling market prices toward the end of 2008, corn and ethanol ending inventories had been purchased and produced, respectively, at prices higher than prevailing spot prices for the commodities at the end of 2008. As a result, we recorded additional losses from this market adjustment of approximately $1.7 million in 2008.
 
-36-

 
Our sales volume resulting from the marketing and sale of ethanol produced by third parties decreased as an overall percentage of our total net sales, as production of our own ethanol has been growing rapidly. Our purchase and sale prices of ethanol produced by third parties typically fluctuate closely with market prices. As a result, our average cost of ethanol purchased from third parties increased in line with the overall increase in our average sales price per gallon.
 
Our net derivative losses were $2,820,000 for 2008 as compared to losses of $4,122,000 for 2007. Included in the net losses for 2008 are net losses of $1,131,000 related to settled non-designated positions.
 
Selling, General and Administrative Expenses
 
Our selling, general and administrative expenses, or SG&A, increased by $1.0 million to $31.8 million for 2008 as compared to $30.8 million for 2007. SG&A, however, decreased as a percentage of net sales due to our significant sales growth. The increase in the dollar amount of SG&A is primarily due to the following factors:
 
● 
payroll and benefits increased by $2,531,000 due to increased administrative staff;
 
● 
bad debt expense increased by $2,216,000 due to growth in accounts receivable and certain customers facing difficult liquidity positions;
 
● 
derivative commissions increased by $1,424,000 due to significant trades during the year; and
 
 
noncash compensation expense increased by $791,000 due to additional restricted stock grant activity during the year.
 
Partially offsetting the foregoing increases were the following decreases:
 
 
professional fees decreased $1,473,000 due to lower consulting fees and temporary staffing during the year; and
 
 
amortization of intangible assets decreased $3,137,000, primarily resulting from a reduction in amortization expense associated with our acquisition of our 42% ownership interest in Front Range, as we have fully amortized a significant portion of the intangible assets associated with the acquisition.
 
Impairment of Goodwill
 
Statement of Financial Accounting Standards, or SFAS, No. 142, Goodwill and Other Intangible Assets, requires us to test goodwill for impairment at least annually. In accordance with SFAS No. 142, we conducted an impairment test of goodwill as of March 31, 2008. As a result, we recorded a non-cash impairment charge of $87,047,000, requiring us to write-off our entire goodwill balances from our previous acquisitions of Kinergy Marketing LLC, or Kinergy, and Front Range. The impairment charge will not result in future cash expenditures.
 
 
-37-

 
Impairment of Asset Group
 
In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, as of September 30, 2008, we performed our impairment analysis for our asset group associated with our suspended plant construction project in the Imperial Valley near Calipatria, California, or the Imperial Project. At September 30, 2008, the asset group consisted of gross property and equipment of $43,751,000. In addition, the Imperial Project had construction-related accounts payable and accrued expenses of $17,245,000. We do not intend to resume construction of the Imperial Project. In November, 2008, we began proceedings to liquidate these assets and liabilities. After assessing the estimated undiscounted cash flows, we recorded an impairment charge of $40,900,000, thereby reducing our property and equipment at September 30, 2008, by that amount. As conditions in the industry and viable financing options become available, we will assess resuming construction. To the extent we are relieved of the related liabilities, we may record a gain in the period in which the relief occurs.
 
Other Income (Expense), Net
 
Other expense decreased by $0.7 million to $6.1 million in 2008 from other expense of $6.8 million in 2007. The decrease in other expense is primarily due to the following factors:
 
● 
increased other income of $9,636,000 primarily related to sales of our business energy tax credits sold as pass through investments to interested purchasers;
 
● 
decreased net mark-to-market losses of $4,180,000 from our interest rate hedges which required that we mark-to-market our ineffective positions in a declining interest rate environment; the ineffectiveness related to our interest rate swaps in 2008 related primarily to the de-designation of our interest rate swaps associated with our debt financing, which is currently being restructured and it is not probable that we will make our required payments as currently structured. In 2007, we recorded a loss of $5,589,000 primarily resulting from the suspension of construction of our Imperial Valley project in the fourth quarter of 2007; and
 
● 
decreased finance cost amortization of $2,708,000 related to our prior financing arrangements, which were replaced by our current financing arrangements, requiring accelerated amortization on the prior financing arrangements.
 
These items were partially offset by:
 
● 
interest expense increased by $10,584,000 as we have increased our debt and ceased capitalizing interest associated with our plant construction program;
 
● 
decreased interest income of $4,346,000 due to our use of cash for construction activities over the past year; and
 
● 
increased bank fees of $866,000 primarily related to our obtaining waivers for our construction financing debt, due to non compliance at the end of 2007 and a requirement that we pay additional bank fees to obtain such waivers during the period.
 
 
-38-

 
Noncontrolling Interest in Variable Interest Entity
 
Noncontrolling interest in variable interest entity relates to the consolidated treatment of Front Range, a variable interest entity, and represents the noncontrolling interest of others in the earnings of Front Range. We consolidate the entire income statement of Front Range for the period covered. However, because we own only 42% of Front Range, we must reduce our net income or increase our net loss for the noncontrolling interest, which is the 58% ownership interest that we do not own. This amount decreased by $62,345,000 to a loss of $52,669,000 in 2008 from income of $9,676,000 in 2007 primarily due to goodwill impairment associated with amounts recorded in the original acquisition of our interests in Front Range.
 
Preferred Stock Dividends
 
Shares of our Series A and B Preferred Stock are entitled to quarterly cumulative dividends payable in arrears an amount equal to 5% and 7% per annum, respectively, of the purchase price per share of the Preferred Stock, or, and only in 2007, at our option, payable in additional shares of Series A Preferred Stock based on the value of the purchase price per share of the Series A Preferred Stock. In 2008, we declared and paid cash dividends on our Series A and B Preferred Stock in the aggregate amounts of $1,709,000 and $2,395,000, respectively.
 
During 2008, the former holder of our Series A Preferred Stock converted all of its shares of Series A Preferred Stock into shares of our common stock. As a result, at December 31, 2008, there were no outstanding shares of Series A Preferred Stock.
 
Deemed Dividend on Preferred Stock
 
During 2008, we recorded a deemed dividend on preferred stock of $761,000 in connection with a subsequent issuance of shares of Series B Preferred Stock. This non-cash dividend reflects the implied economic value to the preferred stockholder of being able to convert the shares into common stock at a price (as adjusted for the value allocated to the warrants) which was in excess of the fair value of the Series B Preferred Stock at the time of issuance. The fair value was calculated using the difference between the conversion price of the Series B Preferred Stock into shares of common stock, adjusted for the value allocated to the warrants, of $4.79 per share and the fair market value of our common stock of $5.65 on the date of issuance of the Series B Preferred Stock. The deemed dividend on preferred stock is a reconciling item and adjusts our reported net loss, together with the preferred stock dividends discussed above, to loss available to common stockholders.
 
 
-39-

 
Year Ended December 31, 2007 Compared to the Year Ended December 31, 2006
 
   
 
                       Results as a Percentage
         
Dollar
   
Percentage
       of Net Sales for the
   
Years Ended
   
Variance
   
Variance
      Years Ended
   
 December 31,
   
Favorable
   
Favorable
     
December 31,
     
2007
     
2006
   
(Unfavorable)
   
(Unfavorable)
     
2007
     
2006
   
(dollars in thousands)
 
Net sales
  $ 461,513     $ 226,356     $ 235,157       103.9 %       100.0 %       100.0 %
Cost of goods sold
    428,614       201,527       (227,087 )     (112.7 )       92.9         89.0  
Gross profit
    32,899       24,829       8,070       32.5         7.1         11.0  
Selling, general and administrative expenses
    30,822       24,641       (6,181 )     (25.1 )       6.6         10.9  
Income from operations
    2,077       188       1,889       1,004.8         0.5         0.1  
Other income (expense), net
    (6,801 )     3,426       (10,227 )     (298.5 )       (1.5 )       1.5  
Income (loss) before noncontrolling interest in variable interest entity and provision for income taxes
    (4,724 )     3,614       (8,338 )     (230.7 )       (1.0 )       1.6  
Noncontrolling interest in variable interest entity
    (9,676 )     (3,756 )     (5,920 )     (157.6 )       (2.1 )       (1.7 )
Loss before provision for income taxes
    (14,400 )     (142 )     (14,258 )     (10,040.9 )       (3.1 )       (0.1 )
Provision for income taxes
                                       
Net loss
  $ (14,400 )   $ (142 )   $ (14,258 )     (10,040.9 )%       (3.1 )%       (0.1 )%
Preferred stock dividends
  $ (4,200 )   $ (2,998 )   $ (1,202 )     (40.1 )%       (0.9 )%       (1.3 )%
Deemed dividend on preferred stock
    (28 )     (84,000 )     83,972       100.0         (0.0 )       (37.1 )
Loss available to common stockholders
  $ (18,628 )   $ (87,140 )   $ 68,512       78.6 %       (4.0 )%       (38.5 )%
 
Net Sales
 
The increase in our net sales in 2007 as compared to 2006 was primarily due to a substantial increase in sales volume, which was partially offset by decreased average sales prices.
 
Total volume of ethanol sold increased by 88.9 million gallons, or 87%, to 190.6 million gallons in 2007 as compared to 101.7 million gallons in 2006. The substantial increase in sales volume is primarily due to a full year of ethanol production at our Madera and Front Range facilities in 2007. Our Madera and Front Range facilities each accounted for less than three months of ethanol production in 2006. In addition, in 2007, we commenced ethanol production at our Columbia facility and also generated increased sales from the purchase and resale of additional supply from third-parties under our ethanol marketing agreements. The production and sale of ethanol and its co-products from our Madera and Columbia facilities, and through Front Range, contributed an aggregate of $194.0 million to our increase in net sales in 2007.
 
Our average sales price per gallon declined 6% to $2.15 in 2007 from an average sales price per gallon of $2.28 in 2006. The average CBOT price per gallon declined 21% to $1.98 in 2007 from an average CBOT price per gallon of $2.52 in 2006. We believe that we were insulated from some of this decline due to our fixed-price ethanol contracts which were partially offset by derivative losses incurred as a result of locking in margins.
 
Cost of Goods Sold and Gross Profit
 
The increase in our cost of goods sold in 2007 as compared to 2006 was predominantly due to increased sales volume and increased corn costs which contributed to higher costs per gallon. Our gross margin declined to 7.1% in 2007 from 11.0% in 2006 primarily due to increased corn costs, lower average sales prices per gallon and losses on derivatives, as further discussed below.
 
Although a large proportion of our sales volume results from the marketing and sale of ethanol produced by third parties, production of our own ethanol began growing rapidly in 2007 as new facilities commenced operations. Our purchase and sale prices of ethanol produced by third parties typically fluctuate closely with market prices. As a result, our average cost of ethanol purchased from third parties decreased in line with the overall decline in our average sales price per gallon.
 
 
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Corn is the single largest component of the cost of our ethanol production. Average corn prices rose significantly in 2007 as compared to 2006, with greater increases occurring in the second half of 2007 than in the first half of the year. These increases pushed our average corn price higher than the average market price for all of 2007 because our corn requirements increased significantly during the second half of 2007 due to the commencement of operations at our Columbia facility in September 2007. Overall, the price of corn had a much larger impact on our production costs per gallon in 2007 than in 2006 due to the higher proportion of sales from production of our own ethanol in 2007 as compared to 2006.
 
Cost of goods sold also increased by $4,122,000 from net losses on derivatives in 2007 as compared to only a nominal amount in 2006. These losses resulted from derivatives that we entered in order to lock in margins during the year and were partially offset by gains from derivatives we entered in order to lock in the price of corn. Of these losses, $1,649,000 was related to open positions at December 31, 2007.
 
Selling, General and Administrative Expenses
 
Our SG&A increased by $6,181,000 to $30,822,000 for 2007 as compared to $24,641,000 for 2006. SG&A, however, decreased as a percentage of net sales due to our significant sales growth. The increase in the dollar amount of SG&A is primarily due to the following factors:
 
● 
payroll and benefits increased by $3,017,000, or 68%, due to increased administrative staff;
 
● 
amortization of intangible assets resulting from our acquisition of our 42% ownership interest in Front Range increased by $2,117,000, as we incurred a full year of amortization compared to less than three months in 2006;
 
● 
SG&A attributable to Front Range increased by $2,042,000 as we incurred a full year of these expenses as compared to less than three months in 2006;
 
● 
consulting and temporary staff expenses increased by $1,950,000, or 126%, due to the retention of additional consulting and temporary staff personnel to assist us in meeting our accounting and public reporting requirements, including as we transitioned our permanent staff to our new corporate headquarters in Sacramento, California; these consulting and temporary staff personnel also assisted us in training new administrative staff members;
 
● 
recruiting, hiring and training expenses increased by $709,000, or 1,055%, employee travel and office setup costs increased by $377,000, or 243%, and rent expense increased by $457,000, or 221%; each of these increases resulted primarily from the relocation of our corporate headquarters in early 2007 from Fresno to Sacramento;
 
● 
external audit costs increased by $582,000, or 312%, due to our overall growth and business initiatives; and
 
● 
travel-related costs increased by $311,000, or 52%, due to expanded operations and new office and facility locations.
 
 
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Partially offsetting the foregoing increases were the following decreases:
 
● 
non-cash compensation expense decreased by $4,023,000, or 64%, due to the completion of vesting of incentive compensation paid to employees and consultants;
 
● 
legal expenses decreased by $918,000, or 43%, primarily due to one-time costs associated with greater legal activity from litigation and business transactions that occurred in 2006; and
 
● 
costs associated with implementing and testing our internal controls and related compliance required under the Sarbanes-Oxley Act of 2002 decreased by $902,000, or 76%, as many costs that occurred in 2006 were related predominantly to our initial implementation and testing of our internal controls.
 
Other Income (Expense), Net
 
Other expense increased by $10,227,000 to $6,801,000 in 2007 from other income of $3,426,000 in 2006. The increase in other expense is primarily due to the following factors:
 
● 
interest expense increased by $1,828,000, or 286%, due to additional borrowings and a full year of interest accruing on outstanding debt; and
 
● 
amortization of interest and financing costs increased by $3,164,000, or 305%, primarily due to an amendment to our construction financing credit facility that reduced its application from five to four facilities and reduced the total amount of available financing; as a result, we wrote off $1,962,000 of unamortized costs associated with our Imperial Valley facility, the construction of which had been suspended; interest and financing costs incurred under the construction phase of each of our facilities which were being capitalized until the corresponding facility became operational; this increase in amortization of interest and financing costs is net of approximately $7,823,000 of additional capitalized amounts over 2006.
 
In addition, we recognized losses of $119,000 and $5,442,000 of effective and ineffectiveness positions, respectively, from our interest rate hedges which required that we mark-to-market our ineffective positions in a declining interest rate environment. The ineffectiveness related to our interest rate swaps and primarily resulted from the suspension of construction of our Imperial Valley facility.
 
Noncontrolling Interest in Variable Interest Entity
 
Noncontrolling interest in variable interest entity relates to the consolidated treatment of Front Range, a variable interest entity, and represents the noncontrolling interest of others in the earnings of Front Range. We consolidate the entire income statement of Front Range for the period covered. However, because we own only 42% of Front Range, we must reduce our net income or increase our net loss for the noncontrolling interest, which is the 58% ownership interest that we do not own. This amount increased by $5,920,000 to $9,676,000 in 2007 from $3,756,000 in 2006 due to the consolidation of Front Range’s operations for all of 2007 as compared to less than three months in 2006.
 
Preferred Stock Dividends
 
Shares of our Series A Preferred Stock are entitled to quarterly cumulative dividends payable in arrears in cash in an amount equal to 5% per annum of the purchase price per share of the Series A Preferred Stock, or, at the time, our option, payable in additional shares of Series A Preferred Stock based on the value of the purchase price per share of the Series A Preferred Stock. In 2007, we declared and paid dividends on our Series A Preferred Stock in the aggregate amount of $4,200,000 comprised of cash dividends in the aggregate amount of $3,150,000 for the first three quarters and a dividend payment-in-kind in the amount of $1,050,000 that was issued in shares of Series A Preferred Stock for the fourth quarter.
 
 
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Deemed Dividend on Preferred Stock
 
We recorded a deemed dividend on preferred stock of $28,000 for 2007 in connection with our issuance of shares of Series A Preferred Stock as a dividend payment-in-kind for the fourth quarter. We also recorded a deemed dividend on preferred stock of $84,000,000 for 2006 in connection with our initial issuance of shares of Series A Preferred Stock. These non-cash dividends reflect the implied economic value to the preferred stockholder of being able to convert these additional shares into common stock at prices which were in excess of the fair value of the Series A Preferred Stock at the times of issuance. The fair value was calculated using the difference between the agreed-upon conversion price of the Series A Preferred Stock into shares of common stock of $8.00 per share and the fair market value of our common stock of $8.21 and $29.27 on the date of issuance of the additional shares of Series A Preferred Stock for 2007 and 2006, respectively. The fair value allocated to the initial issuance of the Series A Preferred Stock in 2006 was in excess of the gross proceeds received of $84,000,000 in connection with the initial sale of the Series A Preferred Stock; however, the deemed dividend on the Series A Preferred Stock for 2006 is limited to the gross proceeds received of $84,000,000. The deemed dividend on preferred stock is a reconciling item and adjusts our reported net loss, together with the preferred stock dividends discussed above, to loss available to common stockholders.
 
Liquidity and Capital Resources
 
Overview and Outlook
 
Our financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As a result of ethanol industry conditions that have negatively affected our business, we do not currently have sufficient liquidity to meet our anticipated working capital, debt service and other liquidity needs in the very near-term. We have suspended operations at three of our four wholly-owned ethanol production facilities due to market conditions and in an effort to conserve capital. We have also taken and expect to take additional steps to preserve liquidity. However, despite any additional cost-saving steps we may take, we believe that we have sufficient working capital to continue operations only until approximately April 30, 2009 at the latest unless we successfully restructure our debt, experience a significant improvement in margins and obtain other sources of liquidity.  
 
We are in default under our construction-related term loans in the aggregate amount of approximately $230 million and under Kinergy’s revolving line of credit as well as $31.5 million in notes payable to another lender. In February 2009, we entered into forbearance agreements with each of the lenders, which were amended in March 2009, under which the lenders agreed to forbear from exercising their rights until April 30, 2009 absent further defaults. Although we are actively pursuing a number of alternatives, including seeking to restructure our debt and seeking to raise additional debt or equity financing, or both, there can be no assurance that we will be successful. If we cannot restructure our debt and obtain sufficient liquidity in the very near term, we may need to seek protection under the U.S. Bankruptcy Code.
 
Quantitative Year-End Liquidity Status
 
We believe that the following amounts provide insight into our liquidity and capital resources. The following selected financial data 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):
 
 
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As of and for the
Year Ended December 31,
         
   
2008
   
2007
   
Variance
 
Current assets
  $ 71,891     $ 82,193       (12.5 )%  
Current liabilities
  $ 360,204     $ 120,079       200.0 %  
Property and equipment, net
  $ 530,037     $ 468,704       13.1 %  
Notes payable, net of current portion
  $ 937     $ 151,188       (99.4 )%  
Cash provided by (used in) operating activities
  $ (55,175 )   $ 16,718       (430.0 )%  
Working capital
  $ (288,313 )   $ (37,886 )     (661.0 )%  
Working capital ratio
    0.20       0.68       (70.6 )%  
 
Change in Working Capital and Cash Flows
 
Working capital decreased to a deficit of $288,313,000 at December 31, 2008 from a deficit of $37,886,000 at December 31, 2007 as a result of a significant increase in current liabilities of $240,125,000 and a slight decrease in current assets of $10,302,000.
 
Current liabilities significantly increased primarily due to an increase in current portion of debt of $294,322,000, as plant financing and operating lines of credit are both in default and under forbearance agreements with the related lenders, as new terms are being negotiated. Other increases in current liabilities are due to an increase in accrued liabilities of $3,809,000, which were partially offset by decreases in accounts payable and accrued liabilities – construction-related of $35,005,000, a decrease in trade accounts payable of $8,607,000, a decrease in retentions of $5,252,000 and a decrease in short-term note payable of $6,000,000 as that note was paid off by the end of the year and a decrease in derivative liabilities of $2,850,000.
 
Current assets decreased primarily due to net decreases in marketable securities and accounts receivable of $11,573,000 and $4,211,000, respectively, the proceeds of which were predominantly used for operations, which were partially offset by an increase in cash and equivalents of $5,759,000 and restricted cash of $1,740,000.
 
Cash used in our operating activities of $55,175,000 resulted primarily from a loss of $146,547,000, noncontrolling interest in variable interest entity of $52,669,000 and a decrease in accounts payable and accrued expenses of $20,579,000, partially offset by impairment of goodwill of $87,047,000, impairment of asset group of $40,900,000, depreciation and amortization of intangibles of $26,635,000 and changes in other assets and liabilities.
 
Cash used in our investing activities of $140,856,000 resulted primarily from purchases of additional property and equipment of $152,635,000, partially offset by proceeds from sales of marketable securities of $11,573,000.
 
Cash provided by our financing activities of $201,790,000 resulted primarily from proceeds from our debt financing and lines of credit of $157,322,000, proceeds from issuances of preferred and common stock of $72,292,000, which were partially offset by cash paid for principal debt payments of $20,787,000, preferred share dividends of $4,104,000, debt issuance costs of $1,818,000 and dividend payments to noncontrolling interests of $1,115,000.
 
 
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Changes in Other Assets and Liabilities
 
Goodwill, net, decreased to $0 at December 31, 2008 from $88,168,000 at December 31, 2007 primarily as a result of our annual impairment analysis which caused us to write the balance down due to a lower current valuation as compared to the original purchase that created the goodwill.
 
Notes payable, net of current portion, decreased to $937,000 at December 31, 2008 from $151,188,000 at December 31, 2007 primarily as a result of an increase from loan proceeds used for construction activities at our ethanol plants which were completed in 2008, which increase was partially offset by amounts reclassified to current liabilities as the loans and Kinergy’s operating line of credit are both in default but presently under a forbearance agreement with the related lenders.
 
Debt Financing
 
Upon completion of our Stockton facility, our construction loans totaling $230 million converted to term loans with scheduled quarterly principal and interest payments due starting on December 31, 2008. We made the first payment at the end of 2008. We have been unable to make subsequent required principal and interest payments on these term loans, resulting in defaults under those loans. In February, 2009, we obtained a waiver and forbearance agreement with our lenders which was extended in March 2009. The waiver and forbearance agreement, as extended, provides that the lenders will forbear from exercising their rights and remedies under the Debt Financing commencing February 17, 2009 and ending on April 30, 2009. Further the waiver and forbearance agreement provides that we may withdraw funds otherwise required to be reserved in two accounts designated solely for the Stockton facility and the other for future debt service payments. The use of these funds provides approximately $5,385,000 million to us for operating activities. Further, the lenders have allowed us to cease payments of principal and interest due during the forbearance period. Upon expiration of the forbearance period, or our earlier default under the terms of the forbearance, we will be required to repay all outstanding amounts owed to our lenders. We are presently attempting to negotiate debt restructuring terms with our lenders. However, we cannot assure you that we will be able to successfully negotiate satisfactory terms with our lenders.
 
Kinergy Line of Credit
 
In February 2009, Kinergy determined that it had violated certain of its covenants, including its financial covenant for 2008. In February 2009, we entered into an amendment and forbearance agreement with our lender which was further amended in March 2009. The amendment identified certain defaults under the loan agreement as to which the lender agreed to forebear from exercising its rights and remedies commencing February 13, 2009 through April 30, 2009. During the forbearance period, Kinergy’s lender has authorized us to use this line of credit for Kinergy’s operations. The agreement reduced the aggregate amount of the credit facility from up to $40,000,000 to up to $10,000,000.
 
The agreement also increased the interest rates applicable to the loan. Kinergy may borrow under the credit facility based upon (i) a rate equal to (a) the London Interbank Offered Rate (“LIBOR”), divided by 0.90 (subject to change based upon the reserve percentage in effect from time to time under Regulation D of the Board of Governors of the Federal Reserve System), plus (b) 4.50% depending on the amount of Kinergy’s EBITDA for a specified period, or (ii) a rate equal to (a) the greater of the prime rate published by Wachovia Bank from time to time, or the federal funds rate then in effect plus 0.50%, plus (b) 2.25% depending on the amount of Kinergy’s EBITDA for a specified period. In addition, Kinergy is required to pay an unused line fee at a rate equal to 0.375% as well as other customary fees and expenses associated with the credit facility and issuances of letters of credit. Kinergy’s obligations under the loan agreement are secured by a first-priority security interest in all of its assets in favor of the lender.
 
Upon expiration of the forbearance period, or our earlier default under the terms of the forbearance, Kinergy will be required to repay all outstanding amounts owed to its lender. We are presently attempting to negotiate debt restructuring terms with this lender. However, we cannot assure you that we will be able to successfully negotiate satisfactory terms with this lender.
 
 
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Notes Payable
 
In February 2009, we notified lenders that we would not be able to pay off their notes in the aggregate amount of $31.5 million due in March 2009. In February 2009, we entered into a forbearance agreement with the lenders which was amended in March 2009. Under the terms of the forbearance agreement, the lenders agreed to forbear from exercising their rights and remedies against us through April 30, 2009. We are presently attempting to negotiate debt restructuring terms with the lenders. However, we cannot assure you that we will be able to successfully negotiate satisfactory terms.
 
Contractual Obligations
 
The following table outlines payments due under our significant contractual obligations (in thousands):

Contractual Obligations
At December 31, 2008
 
2009
   
2010
   
2011
   
2012
   
2013
   
Thereafter
   
Total
 
Sourcing commitments(1)
  $ 28,959     $     $     $     $     $     $ 28,959  
Debt principal(2)
    67,981       15,581       26,176       24,134       13,976       158,509       306,357  
Debt interest(2)
    17,728       15,762       13,462       12,073       10,415       19,132       88,572  
Operating leases(3)
    3,103       3,082       2,701       2,035       1,657       8,794       21,372  
Preferred dividends(4)
    3,202       3,202       3,202       3,202       3,202       3,202       19,212  
Total commitments
  $ 120,973     $ 37,627     $ 45,541     $ 41,444     $ 29,250     $ 189,637     $ 464,472  
 
__________
 
(1)
Unconditional purchase commitments for production materials incurred in the normal course of business.
 
(2)
Payments based on debt agreements as of December 31, 2008, and do not reflect current defaults and any potential change in terms from current negotiations with lenders.
 
(3)
Future minimum payments under non cancelable operating leases.
 
(4)
Represents dividends on 2,346,152 shares of Series B Preferred Stock.
 
The above table outlines our obligations as of December 31, 2008 and does not reflect the changes in our obligations that occurred after that date.
 
Critical Accounting Policies
 
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments 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 amount of net sales and expenses for each period. The following represents a summary of our critical accounting policies, defined as those policies that we believe are the most important to the portrayal of our financial condition and results of operations and that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.
 
Going Concern Assumption
 
We have based our financial statements on the assumption of our operations continuing as a going concern. Our consolidated financial statements do not include any adjustments relating to the recoverability and classification of the recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue our existence.
 
 
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Revenue Recognition
 
We recognize revenue when it is realized or realizable and earned. We consider revenue realized or realizable and earned when it has persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collection is reasonably assured in conformity with Staff Accounting Bulletin No. 104, Revenue Recognition.
 
We derive revenue primarily from sales of ethanol and related co-products. We recognize revenue when title transfers to our customers, which is generally upon the delivery of these products to a customer’s designated location. These deliveries are made in accordance with sales commitments and related sales orders entered into with customers either verbally or in written form. The sales commitments and related sales orders provide quantities, pricing and conditions of sales. In this regard, we engage in three basic types of revenue generating transactions:
 
● 
As a producer.  Sales as a producer consist of sales of our inventory produced at our facilities.
 
● 
As a merchant.  Sales as a merchant consist of sales to customers through purchases from third-party suppliers in which we may or may not obtain physical control of the ethanol or co-products, though ultimately titled to us, in which shipments are directed from our suppliers to our terminals or direct to our customers but for which we accept the risk of loss in the transactions.
 
● 
As an agent.  Sales as an agent consist of sales to customers through purchases from third-party suppliers in which, depending upon the terms of the transactions, title to the product may technically pass to us, but the risk and rewards of inventory ownership remains with third-party suppliers as we receive a predetermined service fee under these transactions and therefore act predominantly in an agency capacity.
 
We have employed the principles detailed in Emerging Issues Task Force, or EITF, Issue No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, as guidance in our revenue recognition policies. Revenue from sales of third-party ethanol and its co-products is recorded net of costs when we are acting as an agent between the customer and supplier and gross when we are a principal to the transaction. Several factors are considered to determine whether we are acting as an agent or principal, most notably whether we are the primary obligor to the customer, whether we have inventory risk and related risk of loss or whether we add meaningful value to the vendor’s product or service. Consideration is also given to whether we have latitude in establishing the sales price or have credit risk, or both.
 
We record revenues based upon the gross amounts billed to our customers in transactions where we act as a producer or a merchant and obtain title to ethanol and its co-products and therefore own the product and any related, unmitigated inventory risk for the ethanol, regardless of whether we actually obtain physical control of the product. When we act in an agency capacity, we record revenues on a net basis, or our predetermined agency fees only, based upon the amount of net revenues retained in excess of amounts paid to suppliers.
 
Consolidation of Variable Interest Entities.
 
We have determined that Front Range meets the definition of a variable interest entity under the Financial Accounting Standards Board’s, or FASB’s, Financial Interpretation No., or FIN, 46(R), Consolidation of Variable Interest Entities. We have also determined that we are the primary beneficiary and we are therefore required to treat Front Range as a consolidated subsidiary for financial reporting purposes rather than use equity investment accounting treatment. As a result, we have consolidated the financial results of Front Range, including its entire balance sheet with the balance of the noncontrolling interest displayed between liabilities and equity, and the income statement after intercompany eliminations with an adjustment for the noncontrolling interest in net income since our acquisition on October 17, 2006. Under FIN 46(R), and as long as we are deemed the primary beneficiary of Front Range, we must treat Front Range as a consolidated subsidiary for financial reporting purposes.
 
 
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Impairment of Intangible and Long-Lived Assets
 
Our intangible assets, including goodwill, were derived from the acquisition of our interest in Front Range in 2006 and our acquisition of Kinergy in 2005 in connection with the Share Exchange Transaction. In accordance with SFAS No. 141, we allocated the respective purchase prices to the tangible assets, liabilities and intangible assets acquired based upon their estimated fair values. The excess purchase prices over the fair values of the assets acquired and liabilities assumed were recorded as goodwill. Our long-lived assets are primarily associated with our ethanol production facilities.
 
We account for goodwill and intangible assets with indefinite lives in accordance with SFAS No. 142. We review these assets at least annually or more frequently if impairment indicators arise. In our review, we determine the fair value of these assets using market multiples and discounted cash flow modeling and compare it to the net book value of the acquired assets. Any assessed impairments will be recorded permanently and expensed in the period in which the impairment is determined. If it is determined through our assessment process that any of our intangible assets require impairment charges, they will be recorded in the line item other operating charges in the consolidated statements of operations. During the year ended December 31, 2008, we performed our annual review of impairment and recognized an impairment loss of $87,047,000, the entire amount of our goodwill. We did not recognize any impairment losses for the years ended December 31, 2007 and 2006.
 
We evaluate impairment of long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. We assess the impairment of long-lived assets, including property and equipment and purchased intangibles subject to amortization, when events or changes in circumstances indicate that suggest the fair value of assets could be less then their net book value. In such event, we assess long-lived assets for impairment by determining their fair value based on the forecasted, undiscounted cash flows the assets are expected to generate plus the net proceeds expected from the sale of the asset. An impairment loss would be recognized when the fair value is less than the related asset’s net book value, and an impairment expense would be recorded in the amount of the difference. Forecasts of future cash flows are judgments based on our experience and knowledge of our operations and the industries in which we operate. These forecasts could be significantly affected by future changes in market conditions, the economic environment, including inflation, deflation and capital spending decisions of our customers. During the year ended December 31, 2008, we recognized an impairment loss on long-lived assets associated with our Imperial Valley ethanol production facility, which construction has been suspended, of $40,900,000. We did not recognize any impairment losses for the years ended December 31, 2007 and 2006.
 
In 2008, we completed construction of our ethanol production facilities, with installed capacity of 220 million gallons per year, our goal since 2005. During 2008, we, along with the ethanol industry as a whole, experienced significant volatility in the prices of ethanol and corn. Further, we incurred significant operating losses in the last half of 2008, which required us to make decisions about operating levels at each of our facilities. As a result, beginning in December 2008 and through the first quarter of 2009, we reduced our production. Currently we have ceased production at our Madera, Magic Valley and Stockton facilities. We continue to operate our Columbia and Front Range facilities. We continue to assess market conditions and when appropriate and with adequate available working capital, we plan to bring these facilities back to operation.  Given the national Renewable Fuel Standards requirements of ethanol, we believe the ethanol industry is viable and will recover in the near term.
 
 
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At December 31, 2008, we performed our forecast of expected future cash flows of our facilities over their estimated useful lives. Such forecasts of expected future cash flows are heavily dependent upon management’s estimates of future market prices for ethanol, our primary product, and corn, our primary production input. As both ethanol and corn costs have fluctuated significantly in the past year, these estimates are highly subjective and are management’s best estimates at this time. Management developed estimated future prices consistent with market forecasts, including forecasts from the United States Department of Agriculture’s long-term forecast. Our forecasts assume that our facilities will only operate during periods when market price conditions yield acceptable operating margins. Our analysis resulted in total estimated undiscounted cash flows over the expected lives of our plant assets in excess of their carrying values. As a result, we did not determine the fair value of our facilities.
 
If 2008 average prices for ethanol and corn were used in our forecast rather than management’s estimate of future market prices, the projections would have resulted in estimated undiscounted cash flows below carrying values which would require us to compute their fair values. If we are required to compute the fair value in the future, we may use the work of a qualified valuation specialist who would assist us in examining replacement costs, recent transactions between third parties and cash flow that can be generated from operations. Given the recent completion of the facilities, replacement cost would likely approximate the carrying value of the facilities. However, there have been recent transactions between independent parties to purchase plants at prices substantially below the carrying value of the facilities. Some of the facilities have been in bankruptcy and may not be representative of transactions outside of bankruptcy. Given these circumstances, should management be required to adjust the carrying value of the facilities to fair value at some future point in time, the adjustment could be significant and could significantly impact our financial position, results of operation and possibly any existing financial debt covenants. No adjustment has been made in these financial statements for this uncertainty.
 
Derivative Instruments and Hedging Activities
 
Our business and activities expose us to a variety of market risks, including risks related to changes in commodity prices and interest rates. We monitor and manage these financial exposures as an integral part of our 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. We account for our use of derivatives related to our hedging activities pursuant to SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, in which we recognize all of our derivative instruments in our statement of financial position as either assets or liabilities, depending on the rights or obligations under the contracts. We have designated and documented contracts for the physical delivery of commodity products to and from counterparties as normal purchases and normal sales. Derivative instruments are measured at fair value, pursuant to the definition found in SFAS No. 107, Disclosures about Fair Value of Financial Instruments. Changes in the derivative’s fair value are recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative’s effective gains and losses to be deferred in accumulated other comprehensive income (loss) and later recorded together with the gains and losses to offset related results on the hedged item in the statements of operations. Companies must formally document, designate and assess the effectiveness of transactions that receive hedge accounting.
 
The estimated gains (losses) on our derivatives were as follows (in thousands):

   
Year Ended December 31,
 
   
2008
   
2007
   
2006
 
Commodity futures
  $ (2,791 )   $ (5,331 )   $ 622  
Interest rate options
    1,382       (5,590 )     (17 )
Total
  $ (1,409 )   $ (10,921 )   $ 605  
 
 
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Allowance for Doubtful Accounts
 
We primarily sell ethanol to gasoline refining and distribution companies and WDG to dairy operators and animal feed distributors. We had significant concentrations of credit risk from sales of our ethanol as of December 31, 2008, as described in Note 1 to our consolidated financial statements. However, those ethanol customers historically have had good credit ratings and historically we have collected amounts that were billed to those customers. Receivables from customers are generally unsecured. We continuously monitor our customer account balances and actively pursue collections on past due balances.
 
We maintain an allowance for doubtful accounts for balances that appear to have specific collection issues. Our 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, we have been unsuccessful in our collection efforts, we consider recording a bad debt allowance for the balance in question. We would eventually write-off accounts included in our allowance when we have determined that collection is not likely. The factors considered in reaching this determination are the apparent financial condition of the customer, and our success in contacting and negotiating with the customer.
 
During the years ended December 31, 2008, 2007 and 2006, we recognized $2,191,000, $58,000 and $83,000, respectively, in bad debt expenses as a result of this policy.
 
Costs of Start-up Activities
 
Start-up activities are defined broadly in Statement of Position 98-5, Reporting on the Costs of Start-Up Activities, as those one-time activities related to opening a new facility, introducing a new product or service, conducting business in a new territory, conducting business with a new class of customer or beneficiary, initiating a new process in an existing facility, commencing some new operation or activities related to organizing a new entity. Our start-up activities consist primarily of costs associated with new or potential sites for ethanol production facilities. We expense all the costs associated with a potential site, until the site is considered viable by management, at which time costs would be considered for capitalization based on authoritative accounting literature. These costs are included in selling, general, and administrative expenses in our consolidated statements of operations.
 
Impact of New Accounting Pronouncements
 
In June 2008, the FASB ratified EITF Issue No. 07-5, Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock. EITF No. 07-5 mandates a two-step process for evaluating whether an equity-linked financial instrument or embedded feature is indexed to the entity’s own stock. EITF No. 07-5 is effective for us beginning with its first quarter ended March 31, 2009. We do not expect the adoption of EITF No. 07-5 will have a material impact on our financial condition or results of operations.
 
In March 2008, the FASB issued SFAS No. 161, Disclosure about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133. SFAS No. 161 changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement No. 133 and its related interpretations and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. We do not expect the adoption of SFAS No. 161 to have a material impact on our financial condition or results of operations.
 
 
-50-

 
In December 2007, the FASB issued SFAS No. 141(R), Business Combinations. SFAS No. 141(R) retains the fundamental requirements in SFAS No. 141, Business Combinations, that the acquisition method of accounting be used for all business combinations and for an acquirer to be identified for each business combination. SFAS No. 141(R) requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions specified in SFAS No. 141(R). In addition, SFAS No. 141(R) requires acquisition costs and restructuring costs that the acquirer expected but was not obligated to incur to be recognized separately from the business combination, therefore, expensed instead of part of the purchase price allocation. SFAS No. 141(R) will be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Early adoption is prohibited. We will adopt SFAS No. 141(R) to any business combinations after January 1, 2009.
 
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment to ARB No. 51. SFAS No. 160 changes the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Early adoption is prohibited. Upon adoption on January 1, 2009, we will present our noncontrolling interest in variable interest entity within stockholders’ equity in our consolidated balance sheets. We do not expect the adoption of SFAS No. 160 to have a material impact on our financial condition or results of operations.
 
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk.
 
We are exposed to various market risks, including changes in commodity prices and interest rates. Market risk is the potential loss arising from adverse changes in market rates and prices. In the ordinary course of business, we enter into various types of transactions involving financial instruments to manage and reduce the impact of changes in commodity prices and interest rates. We do not enter into derivatives or other financial instruments for trading or speculative purposes.
 
Commodity RiskCash Flow Hedges
 
As part of our risk management strategy, we use derivative instruments to protect cash flows from fluctuations caused by volatility in commodity prices for periods of up to twelve months. These hedging activities are conducted to protect gross margins to reduce the potentially adverse effects that market volatility could have on operating results by minimizing our exposure to price volatility on ethanol sale and purchase commitments where the price is to be set at a future date and/or if the contract specifies a floating or index-based price for ethanol that is based on either the New York Mercantile Exchange price of gasoline or the Chicago Board of Trade price of ethanol. In addition, we hedge anticipated sales of ethanol to minimize our exposure to the potentially adverse effects of price volatility. These derivatives are designated and documented as SFAS No. 133 cash flow hedges and effectiveness is evaluated by assessing the probability of the anticipated transactions and regressing commodity futures prices against our 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 year ended December 31, 2008, a loss from ineffectiveness in the amount of $991,000 and an effective gain in the amount of $566,000 were recorded in cost of goods sold. For the year ended December 31, 2007, a gain from ineffectiveness in the amount of $2,832,000 and an effective loss in the amount of $1,680,000 were recorded in cost of goods sold. For the year ended December 31, 2006, losses from ineffectiveness in the amount of $239,000 and an effective loss in the amount of $438,000 were recorded in cost of goods sold. For the year ended December 31, 2006, an effective gain in the amount of $1,281,000 was recorded in sales. The notional balance of these derivatives as of December 31, 2008 and 2007 was $0 and $2,427,000, respectively.
 
 
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Commodity RiskNon-Designated Derivatives
 
As part of our risk management strategy, we use forward contracts on corn, crude oil and reformulated blendstock for oxygenate blending gasoline to lock in prices for certain amounts of corn, denaturant and ethanol, respectively. These derivatives are not designated under SFAS No. 133 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. We recognized losses of $2,395,000 (of which $1,131,000 is related to settled non-designated hedges), $6,484,000 and $0 as the change in the fair value of these contracts for the year ended December 31, 2008, 2007 and 2006, respectively. The notional balances remaining on the contracts as of December 31, 2008 and 2007 were $4,215,000 and $29,999,000, respectively.
 
Interest Rate Risk
 
As part of our interest rate risk management strategy, we use derivative instruments to minimize significant unanticipated earnings fluctuations that may arise from rising variable interest rate costs associated with existing and anticipated borrowings. To meet these objectives we purchased interest rate caps and swaps. The rate for notional balances of interest rate caps ranging from $4,268,000 to $18,990,000 is 5.50%-6.00% per annum. The rate for notional balances of interest rate swaps ranging from $543,000 to $57,654,000 is 5.01%-8.16% per annum.
 
These derivatives are designated and documented as SFAS No. 133 cash flow hedges and effectiveness is evaluated by assessing the probability of anticipated interest expense and regressing the historical value of the rates against the historical value in the existing and anticipated debt. Ineffectiveness, reflecting the degree to which the derivative does not offset the underlying exposure, is recognized immediately in other income (expense). For the year ended December 31, 2008, gains from ineffectiveness in the amount of $4,999,000, gains from effectiveness in the amount of $75,000 and losses from undesignated hedges in the amount of $6,456,000 were recorded in other income (expense). These gains and losses resulted from our efforts to restructure our debt financing and therefore, making it not probable that the related borrowings would be paid as designated. As such we de-designated certain of our interest rate caps and swaps.
 
For the year ended December 31, 2007, losses from ineffectiveness in the amount of $4,836,000, losses from effectiveness in the amount of $147,000 and losses from undesignated hedges in the amount of $606,000 were recorded in other income (expense). For the year ended December 31, 2006, ineffectiveness in the amount of $24,000 was recorded in other income (expense).
 
We marked all of our derivative instruments to fair value at each period end, except for those derivative contracts which qualified for the normal purchase and sale exemption pursuant to SFAS No. 133.
 
 
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Accumulated Other Comprehensive Income (Loss)
 
Accumulated other comprehensive income (loss) relative to derivatives for the year ended December 31, 2008 is as follows (in thousands):
 
   
Commodity Derivatives
   
Interest Rate Derivatives
 
   
Gain/(Loss)*
   
Gain/(Loss)*
 
Beginning balance, January 1, 2008
  $ (455 )   $ (1,928 )
Net changes
          (2,637 )
Less:  Amount reclassified to cost of goods sold
    455        
Less:  Amount reclassified to other income (expense)
          4,565  
Ending balance, December 31, 2008
  $     $  
—————
*Calculated on a pretax basis
 
The estimated fair values of our derivatives were as follows (in thousands):

   
December 31,
 
   
2008
   
2007
 
Commodity futures
  $ (951 )   $ (1,649 )
Interest rate options
    (6,545 )     (7,091 )
Total
  $ (7,496 )   $ (8,740 )
 
Material Limitations
 
The disclosures with respect to the above noted risks do not take into account the underlying commitments or anticipated transactions. If the underlying items were included in the analysis, the gains or losses on the futures contracts may be offset. Actual results will be determined by a number of factors that are not generally under our control and could vary significantly from the factors disclosed.
 
We are exposed to credit losses in the event of nonperformance by counterparties on the above instruments, as well as credit or performance risk with respect to our hedged customers’ commitments. Although nonperformance is possible, we do not anticipate nonperformance by any of these parties.
 
Financial Statements and Supplementary Data.
 
Reference is made to the financial statements included in this report, which begin at Page F-1.
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
 
None.
 
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 and Exchange Act of 1934, as amended (“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 December 31, 2008 that our disclosure controls and procedures were effective at a reasonable assurance level.
 
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Management’s Report on Internal Control Over Financial Reporting
 
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that:
 
 
(i)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets;
 
 
(ii)
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
 
 
(iii)
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material affect on our financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
A material weakness is defined by the Public Company Accounting Oversight Board’s Audit Standard No. 5 as being a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis by the company’s internal controls.
 
Management assessed and evaluated the effectiveness of our internal control over financial reporting as of December 31, 2008. Based on the results of management’s assessment and evaluation, our Chief Executive Officer and Chief Financial Officer concluded that as of December 31, 2008, our internal control over financial reporting was effective.
 
In making its assessment of our internal control over financial reporting, management used criteria issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in its Internal Control—Integrated Framework. Our independent registered public accounting firm, Hein & Associates LLP, independently assessed the effectiveness of our internal control over financial reporting. Hein & Associates LLP has issued an attestation report concurring with management’s assessment, which is included herein.
 
 
-54-

 
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.
 
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.
 
Attestation Report of Independent Registered Public Accounting Firm
 
 
-55-


 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Audit Committee and Management
Pacific Ethanol, Inc.
Sacramento, California
 
We have audited Pacific Ethanol, Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Pacific Ethanol, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company's internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, Pacific Ethanol, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Pacific Ethanol, Inc. as of December 31, 2008 and 2007, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008, of Pacific Ethanol, Inc. and our report dated March 31, 2009 expressed an unqualified opinion thereon.
/s/ HEIN & ASSOCIATES LLP
 
Irvine, California
March 31, 2009
 
Item 9A(T).
Controls and Procedures.
 
 
Not applicable.
 
Item 9B.
Other Information.
 
None.
 
 
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PART III
 
Directors, Executive Officers and Corporate Governance.
 
The information under the captions “Information about our Board of Directors, Board Committees and Related Matters” and “Section 16(a) Beneficial Ownership Reporting Compliance,” appearing in the Proxy Statement, is hereby incorporated by reference.
 
Executive Compensation.
 
The information under the caption “Executive Compensation and Related Information,” appearing in the Proxy Statement, is hereby incorporated by reference.
 
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
 
The information under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information,” appearing in the Proxy Statement, is hereby incorporated by reference.
 
Item 13.
Certain Relationships and Related Transactions, and Director Independence.
 
The information under the captions “Certain Relationships and Related Transactions” and “Information about our Board of Directors, Board Committees and Related Matters—Director Independence” appearing in the Proxy Statement, is hereby incorporated by reference.
 
Principal Accounting Fees and Services.
 
The information under the caption “Principal Accounting Fees and Services,” appearing in the Proxy Statement, is hereby incorporated by reference.
 
PART IV
 
Exhibits, Financial Statement Schedules.
 
(a)(1) Financial Statements
 
Reference is made to the financial statements listed on and attached following the Index to Consolidated Financial Statements contained on page F-1 of this report.
 
(a)(2) Financial Statement Schedules
 
None.
 
(a)(3) Exhibits
 
Reference is made to the exhibits listed on the Index to Exhibits.
 
 
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Index to Financial Statements
 
 
Report of Independent Registered Public Accounting Firm
F-2
   
Consolidated Balance Sheets as of December 31, 2008 and 2007
F-3
   
Consolidated Statements of Operations for the Years Ended December 31, 2008, 2007 and 2006
F-5
   
Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2008, 2007 and 2006
F-6
   
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2008, 2007 and 2006
F-7
   
Consolidated Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and 2006
F-10
   
Notes to Consolidated Financial Statements
F-12
 
F-1

 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors
Pacific Ethanol, Inc.
Sacramento, California
 
We have audited the accompanying consolidated balance sheets of Pacific Ethanol, Inc. as of December 31, 2008 and 2007, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pacific Ethanol, Inc. at December 31, 2008 and 2007, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.
 
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1, the Company is in default under its loan agreements and has entered into forbearance agreements with each of the lenders under which the lenders agreed to forbear from exercising their rights until April 30, 2009 absent further defaults. In addition, the Company does not currently have sufficient liquidity to meet its anticipated working capital, debt service and other liquidity needs in the very near term-term.  These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1 to the financial statements. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Pacific Ethanol, Inc.’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 31, 2009 expressed an unqualified opinion on the effectiveness of Pacific Ethanol, Inc’s internal control over financial reporting.
 
/s/ HEIN & ASSOCIATES LLP
 
Irvine, California
March 31, 2009

F-2


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

   
December 31,
 
ASSETS
 
2008
   
2007
 
Current Assets:
           
Cash and cash equivalents
  $ 11,466     $ 5,707  
Investments in marketable securities
    7,780       19,353  
Accounts receivable, net of allowance for doubtful accounts of $2,210 and $58, respectively
    23,823       28,034  
Restricted cash
    2,520       780  
Inventories
    18,408       18,540  
Prepaid expenses
    2,279       1,498  
Prepaid inventory
    2,016       3,038  
Derivative instruments
    7       1,613  
Other current assets