Friday, December 15, 2006

Catching a Few Rays

In the last post, “Its Tough Being Green,” there was a promise of a series on the biofuel industry. Biofuel companies, in particular the ethanol producers, are the darlings of Wall Street these days. Capital from both public and venture investors is pouring into the industry. Is every aspiring biofuel producer going to be profitable? Perhaps the answer is no.

Biofuels, particularly ethanol, have been around for decades. It has taken the escalating cost of oil to get people to take biofuels seriously as an energy source. That is surprising, since biofuels are just another form of stored solar energy like coal or petroleum. For example, coal represents energy “captured” from the sun by photosynthesis of ancient plants that were compressed and stored in the earth. Biofuel processes aim to release the same solar energy “captured” by present-day plants without the 400,000-year wait!

From a business standpoint, accelerating production processes and reducing the time to produce a finished product almost always make sense. Usually it means eliminating excesses. However, with biofuels, it involves paying for work the earth did naturally and without charge to compress and store all those ancient plants. It also means competing with other users for raw material supplies. Plant-eating dinosaurs all died off, leaving no objection to plants going for coal and oil. The case is quite different for present-day plants and other organic material.

While the coal and oil industries are analyzed as an extraction setup with transportation and storage costs, the biofuel industry will be understood more as a process manufacturing model. A raw material is converted to a final product and then delivered to end-users. Basically there are three biofuel processes each requiring particular organic materials or “feed stock.” We look first at fermentation and then anaerobic digestion and transesterification.

Fermentation produces alcohols like ethanol, methanol, butanol and propanol. Since fermentation is best accomplished using feed stock that is high in sugar, almost all the ethanol producers that are springing up across the U.S. are using corn. In Brazil, ethanol is made from sugar cane and palm oil is in use in Southeast Asia. Rapeseed and flaxseed are used in Europe. Since each of these have alternative uses for human or animal feeds, these are most susceptible to price increases. The
Renewable Fuel Association keeps are fairly up to date list of ethanol producers around the U.S., showing feed stock and production capacity.

U.S. ethanol producers have pooh-poohed environmentalist and humanist objections to using a food-stuff for fuel production. They point to unused corn stock piled in the U.S. as evidence of supply exceeding demand. That might be a valid analysis if they U.S. were the only source of demand for corn. On a global basis there is still unmet demand for corn as the emerging economies have increased interest in and ability to pay for high protein content food. The corn stock pile has more to do with transportation bottlenecks than with sated demand.

Ethanol producers also point to the ability of U.S. farmers to bring more acres into production. Indeed, a significant number of acres are expected to be removed from federal set-aside programs in 2007. Many of these acres were originally placed in fallow because the land was of marginal quality in the first place, requiring substantial irrigation and fertilizer applications to yield crops.

Thus ethanol producers using corn are perhaps the most susceptible to price pressures and therefore margin erosion. Furthermore, it not simply a matter of competing uses. Corn supplies at the margin will come at a high cost. Thus far of the 109 ethanol producers in production and 57 under construction, only five do not rely on corn as a feed stock: Golden Cheese Company of California uses cheese whey; Liquid Resources of Ohio, Merrick & Co. of Colorado, and Wind Gap Farms of Georgia use waste beer; and U.S. Energy Partners of Kansas uses milo and wheat starch. In each of these situations the ethanol producer has easy access to feed stocks that would otherwise be considered waste.

A mitigating factor for ethanol producers using corn is the ability to offset high feed stock prices with the sale of secondary outputs, principally distillers grain. There is already a market for distiller grain established between beverage ethanol and animal feed producers. The protein content of distillers grain makes it an attractive animal feed. According to the
Distillers Grain Technology Council, dried distillers grains with solubles (DDGS) are typically lower cost per pound (20 cents) than corn (50 cents) but offer higher protein content of 28% versus 8% for corn. Of course, as distillers grain supplies increase from the many ethanol plants, the price has declined, reducing the value of distillers grain by-products.

The upshot here for investors is that evaluating each and every one of the public ethanol producers requires a careful look at feed stock costs and by-product prices. The ethanol producer stock in the Crystal Equity Research "Green Index" now includes: ADM, AVR, EHNX, GPRE, MGPI, PEIX, VSE, XNL and soon BIOF.

Since anaerobic digestion processes rely on waste materials like straw, wood chips, rice husks, cow manure and even sewage, most investors might think there would be no raw material cost issues. That would be short sighted. Most of these waste material feed stocks do not transport with ease, driving up the cost of what might otherwise be available for next to nothing. Ditto, for biodiesel producers using waste oils in transesterification processes. Biodiesel stocks in our index include: EBOF, OTD and EPG. (The
U.S. Environmental Protection Agency and the National Biodiesel Board provide good explanations for how each of these processes work.)

Plant location and transportation issues will be taken up in an upcoming post. We will be looking at the trade-offs biofuel producers are making between the location of facilities near feed stock sources versus near customers as well as the selection of transportation methods.

At the very earliest stages of a new industry, investors can throw a little money at every company and at least some will be successful. As the biofuel industry moves toward volume production, investors need to be more discriminating. The successful biofuel operations will be those that can manage the cost of feed stocks.

The next issues we explore are facility and process costs. It takes “fuel” to make “fuel.” Which companies can produce more than they burn?

Neither the author of the Small Cap Copy web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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