Ethanol: Behind the Buzz

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From the White House to Wall Street, ethanol has moved to the heart of national debate about energy, security and the environment.

Its champions promise that it will win energy independence for the U.S.; aid its farmers; weaken hostile oil-subsidized regimes in Tehran, Caracas and Moscow; and better the environment. But the skeptics see little more than a massive agricultural subsidy dressed in patriotic and green rhetoric.

In March, President Bush traveled to Brazil to sign a landmark agreement encouraging ethanol innovation and trade, and then to Detroit to press the CEOs of General Motors(GM), Ford(F) and DaimlerChrysler(DCX) to produce ethanol "flex-fuel" vehicles.

The truth, unsurprisingly, is more complex and creates an array of investment opportunities.

Defining the Product

Ethanol fuel is identical to the alcohol in your merlot or martini. It is less potent than gasoline, providing 75% less energy per gallon, and is commonly blended with gasoline for retail sale. Although conventional auto engines can utilize low-ethanol fuel concentrations without alteration, greater concentrations -- such as the "E85" 85% ethanol standard in the U.S. -- require "flex-fuel" engine modification.

Production is booming. Global output of ethanol more than doubled between 2000 and 2005. It comprises the bulk of the worldwide biofuel market, which is forecast to grow to $80.9 billion by 2016 from $20.5 billion in 2006. The U.S. and Brazil dominate, dividing more than 70% of the ethanol market evenly between them, with the European Union and South and Central America capturing most of the remainder.

Much like liquor, ethanol can be distilled from different ingredients through various methods. Three ingredients dominate the industry: sugar, corn and cellulose. Although they produce identical final products, each raises different technological, commercial and political issues.

Sugar ethanol is produced from sugar cane and beets, mainly in Brazil. Because sugar can be fermented directly into ethanol, production is efficient and yields a healthy 8.3:1 "energy balance" -- the ratio of energy produced by a fuel to the energy needed to manufacture it -- according to the International Energy Agency. Indeed, among varieties of ethanol, only sugar-based ethanol can compete with gasoline, unaided by tariff or direct subsidy. It also leaves a clean carbon footprint, emitting 80% less net greenhouse gases than gasoline.

The growth potential for sugar ethanol is significant. In Brazil alone, investors are planning to put some $14.6 billion into expanding production capacity, and by 2012, expect to be producing 9.5 billion gallons of ethanol annually. A study commissioned by Brazil's Ministry of Science and Technology concludes that Brazil could increase exports to more than 50 billion gallons, one-tenth of current world gasoline production, by 2025. Other South American and Caribbean nations are also expanding sugar ethanol production, and Africa offers additional potential growers.

Ethanol from corn is costlier, dirtier and less efficient than sugar-based ethanol. Because corn contains less energy and is more difficult to convert into fuel, it yields a meager 1.3:1 energy balance at a 50% higher direct cost than sugar ethanol. Net greenhouse gas emissions are little better than gasoline and prospects for growth are constrained by limited cropland and competition from food markets. Simply meeting President Bush's 35-billion-gallon oil reduction goal through domestic ethanol production would require doubling U.S. corn output.

However, what corn ethanol lacks in intrinsic value, it more than compensates for in political clout. Powerful agribusiness lobbies and farm-state representatives in the U.S. have worked to secure huge subsidies for corn ethanol and to erect powerful barriers to imported sugar ethanol. The U.S.' longstanding 54-cents-per-gallon tariff on imported ethanol effectively nullifies sugar ethanol's intrinsic cost advantage, and corn subsidies that exceeded $8 billion last year drive input costs to artificially low levels.

Cellulosic ethanol is the holy grail of biofuels. It can be collected from a much wider variety of biomass than corn or sugar plants, including agricultural refuse, switchgrass and wood. However, its conversion is also more difficult. Long cellulose chains that form plant walls must be broken down to obtain sugars for fermentation. A host of methods are currently under study and some demonstration-scale plants are operational. Nevertheless, the technology remains unproven on an industrial scale and commercial viability lies years away.

Cellulosic ethanol's promise is as alluring as it seems remote. According to the U.S. Department of Energy, cellulosic ethanol production can provide an energy balance of 2.6:1 with dedicated inputs and 5:1 with agricultural residue, as well as a net 80% to 100% reduction of greenhouse gases over gasoline. Because production utilizes the entire plant and not just the foodstuff, its energy yield can exceed 1,000 gallons per planted acre, compared to 660 for Brazilian sugar and 400 for U.S. corn. And unlike corn and sugar, no one eats switchgrass or willow trees, meaning that cellulose inputs do not face the cost pressures and political risk that comes with competing against consumers for food. Finally, the diversity of suitable cellulose biomass makes viable worldwide production, offering virtually limitless capacity and easy input substitution.

Enter Politics

Although ethanol may one day compete without subsidies or tariffs, its fortunes today are a result of politics as much as economics. Four political considerations shape current policy: domestic agriculture, energy independence, regional influence and the environment.
For most of its history, domestic farm interests have been ethanol's raison d'etre. In the U.S., a potent combination of agribusiness money and disproportionate farm-state power in the Senate have effectively orchestrated themes of patriotism and Jeffersonian citizen-farmer imagery to the tune of more than $8 billion in 2006 subsidies and strict import tariffs. Support for corn ethanol handouts is as nonpartisan as the need for farm-state votes. While the farm lobby views warily any efforts to encourage foreign sugar ethanol production, it embraces cellulosic ethanol research and development, which may permit farmers to wring more value out of existing crops and grow biomass inputs on land unsuitable for traditional farming.
Energy independence is today's fashionable rationale for promoting ethanol production. Proponents contend that the U.S.' "addiction" to foreign oil constricts its foreign policy latitude, increases its economic vulnerability and subsidizes some of the world's most troublesome regimes. By reducing that dependence through energy substitutes like ethanol, the U.S. hopes to strengthen its own hand and weaken those of its adversaries.

As a practical matter, the near-term prospects for driving down world oil prices through ethanol substitution are marginal because of the small volume of ethanol compared to the increasing demand from countries like China and India. Nevertheless, advocates believe that ethanol will play an important role in concert with efficiency, conservation and diversification efforts.

The U.S.-Brazil Ethanol Agreement earlier this year was about power, not energy. Since 9/11, anti-American sentiment in South America waxed as populations grew disillusioned with International Monetary Fund austerity prescriptions and with free-trade agreements that cost jobs and did not deliver benefits. Agitated and funded by Venezuelan leader Hugo Chavez, who dispensed populist rhetoric and windfall oil profits liberally, voters turned left and governments looked East. Over the last two years, elections in Venezuela, Brazil, Chile, Bolivia, Nicaragua and Ecuador empowered leftist leaders and the region expanded cooperation with countries like Iran and China. Washington hopes ethanol will help to reverse this trend. By encouraging the development and export of new ethanol technologies to South and Central American neighbors, the U.S. seeks to strengthen economic ties to the region and diminish Venezuelan, Chinese and Middle Eastern influence.

Advocates trumpet ethanol as green energy. Although corn ethanol's environmental credentials are disputed, replacing oil consumption with sugar or cellulosic ethanol could reduce related greenhouse gas emissions on the order of 80% to 100%. It would also lower tailpipe air pollution as well as contaminants from extraction and refinement. Risks of increased greenhouse gas emissions from production of nitrogen-based fertilizer and accelerated rainforest deforestation complicate the picture, but environmental impact will remain one of ethanol's chief selling points.

This complex and fluid mix of domestic and international politics, evolving technology and agricultural and energy commerce creates uncertainties and investment opportunities.

The Ethanol Investing Opportunity

Ethanol's cheerleaders sometimes sound like they've been drinking from their fuel tanks. Their promises of energy independence, greenhouse gas reduction, strategic security and agricultural growth smack of barroom bluster. Sober analysis reveals a more nuanced picture, but one that does provide real long-term opportunities. Let's examine five: industrial production, technological innovation, regulatory arbitrage, market mechanics and renewable energy funds.

The first investment approach is in ethanol production. The space is attractive because it is more developed than the rest of the ethanol value chain and is easily accessed through public markets. The U.S. market is fairly consolidated with Archer Daniels Midland(ADM) controlling 40%, and the top 10 producers accounting for roughly 70%.

Government subsidies and ethanol mandates virtually guarantee top-line industry growth. Profitability, however, will be driven by the prices of foodstuff inputs and oil. In choosing between producers, investors will therefore want to consider both their relative competitiveness and the extent to which investors want to hedge exposure to oil and foodstuff prices.

Although pure-play ethanol producers such as Verasun Energy(V) and Aventine Renewable Energy(AVR) stand to profit handsomely if oil prices rise and corn prices fall, they will bear the full brunt of an oil price decline, as they did in 2006 when the stocks fell nearly 50% after oil retreated from its summer high. By contrast, large agribusiness producers enjoy a natural hedge and can look to their food, feed and industrial products to cushion the impact of falling oil prices. Domestically, ADM's market-leader position in ethanol production, product diversification and developed infrastructure make it an attractive ethanol bet.

Another interesting opportunity may lie abroad in Brazil's largest ethanol and sugar producer, Cosan, which trades under the ticker CSAN3 on the Brazilian Bovespa exchange.

Brazil enjoys the world's lowest production cost for sugar and its exports account for well over one-third of globally traded volume -- market share that is likely to increase in the wake of a recent WTO ruling reducing exports of highly subsidized EU sugar. Ethanol demand should grow even more quickly. Analysts predict that Brazil's domestic demand could nearly double from today's 13 billion liters to 22 billion liters by 2012, driven by the increased penetration of flex-fuel and ethanol vehicles, and energy-hungry Asian economies stand ready to buy up excess supply.

With the high production flexibility between sugar and ethanol, Cosan should be able to move nimbly between the products in response to fluctuating prices. Moreover, Cosan's scale gives it access to cheaper credit and greater bargaining power with suppliers relative to its domestic competitors, advantages that should help it to expand quickly through acquisition in Brazil's fragmented sugar production market.

Trade on Technological Innovation

Ethanol's future lies in cellulose. Although improvements in traditional inputs and technology will continue to garner public support and yield modest efficiency gains, the breakthrough opportunities lie in developing industrial-scale cellulosic ethanol production. Alternative energy start-ups across the world are breeding varieties of trees and prairie grasses that grow faster and yield more energy per acre than native plants. Moreover, new technologies and production methods aim to more than double current corn and sugar ethanol yields by converting their agricultural waste into cellulosic ethanol and energy. This would permit "closed loop" biorefineries in which all of the energy needed for production is generated during the process.

Most cellulosic ethanol companies, such as Iogen and Genencor, are private or wholly owned subsidiaries of larger agribusiness companies, but investors should watch for them to turn to public markets to finance expansion or harvest cash. Some are already public, however, and one of the best may be Novozymes, a leading Danish biotech company focused on the industrial applications of enzymes and microorganisms.

Novozymes has been at the international forefront of cellulosic ethanol innovation, and the U.S. Department of Energy selected it to pursue government-funded research that significantly reduced the price of cellulose enzymes. Although slowdowns in other product areas have dampened analysts' enthusiasm for the company in the near term, Novozymes' cellulosic ethanol development continues apace and is anticipated to lead future growth.

Regulatory Arbitrage

Cracks in the U.S.' 54-cent-per-gallon tariff on imported ethanol create arbitrage opportunities. Specifically, under CAFTA, Caribbean nations can export domestically grown and processed ethanol tariff-free. In addition, under the Caribbean Basin Initiative, Caribbean nations can perform last-step production of partially-processed ethanol from countries like Brazil and export it to the U.S. tariff-free so long as the total of such exports does not exceed 7% of U.S. production.

Last year, the U.S. imported approximately 200 million gallons of Brazilian-grown ethanol in this manner. With the U.S.-Brazil Ethanol Agreement's goal of increasing regional ethanol technology export and the U.S.' plans to increase significantly domestic ethanol production (effectively raising the 7% volume limit on Caribbean last-stage processing), interesting opportunities emerge.

The simplest play -- pure price arbitrage -- seems unsustainable.

Once ethanol becomes a market-traded commodity, opportunities for price arbitrage should disappear as the windfall of tariff-free ethanol resale is priced into the spot market. Therefore, the most attractive investments would seem to lie in ethanol plants of tariff-free nations, because they will capture value from both increased domestic production and the increased volume of last-step processing of Brazilian ethanol.

International investors are already seizing on the opportunity. Maple, a U.S. energy investment group, plans to invest $120 million in a Peruvian ethanol plant subject to a tariff-waiver under the Andean Trade Promotion and Drug Eradication Act. International agricultural giants Cargill and Brazil's Coimex Trading have also entered into joint ventures with Caribbean companies to exploit the tariff exemptions.

Money in Market Mechanics

Anytime a new international commodity market develops, chances are there is money to be made investing in its mechanics. In this instance, the promising opportunities seem to lie not in market-making itself, but in delivering market orders.

Although ethanol trading will generate real profits, it may be difficult to find a pure-play investment to capture them. Ethanol is likely to be traded on the same big exchanges through the same market-makers and be the subject of the same types of derivative financial instruments and ancillary services as other commodities. Consequently, trading-related returns will be buried deep in market-makers' profit and loss statements, dwarfed by the mix of other investment activities.

While there may not be good opportunities in trading orders, there should be in delivering them. The development of a commodity ethanol market should increase both gross production and international trading. Whereas today most ethanol is consumed domestically, ethanol commodity markets will connect efficient South American producers with energy-hungry Asian economies.

Physically delivering these large quantities of ethanol around the world will require development of new transport infrastructure. Specifically, market growth is creating investment opportunities in short-railroad construction, pipeline construction, and railcar and trucking manufacturing. In late February, Brazil's state-run oil firm Petrobras, Japan's Mitsui & Co. and a Brazilian construction firm signed a memorandum of intent to study the construction of a pipeline in Brazil used to help export ethanol to Japan.

In the U.S., rail manufacturers such as American Railcar Industries (ARII) and Trinity(TRN) are sold out well into next year on ethanol tankcar orders and profits have been on the rise.

Finding the Right Funds

Investing in ethanol opportunities can be difficult for individual investors because assets often lie on foreign exchanges or in private companies. Specialty investment funds can give investors access to these opportunities and provide valuable expertise. While no funds appear to focus exclusively on ethanol-related investment, several hold portfolios in renewable energy products and services. Some of the factors that drive the ethanol market also drive other renewable energy sources and fund managers are well-positioned to discover and exploit ethanol-related investment.

The leading fund is the PowerShares WilderHill Clean Energy Portfolio(PBW), an exchange-traded fund that seeks to track the WilderHill Clean Energy Index. The fund is up more than 12% since the beginning of the year, buoyed in part by growing focus on clean energy at both ends of Pennsylvania Avenue and the Supreme Court's April 2 ruling that the Environmental Protection Agency has jurisdiction to regulate greenhouse gas emissions.

 

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