Friday, January 19, 2007

Biofuel "Gravy Train"

Ethanol producers get a bit of boost from tax credits created by Congress to encourage the industry. At this time the $0.51 per gallon tax credit expires in 2010, but legislation was introduced this last week in the U.S. to make it permanent.

Nonetheless, the ethanol gravy train is looking less rewarding by the day as the price of crude oil teeters on the edge of $50.00 a barrel. Since biofuels are sold as substitutes for fossil fuel, the price of crude oil is a key barometer in determining the price biofuels can command in the commodity markets. This level has been suggested as the magic number between profit and loss for the ethanol producers.

In case anyone is wondering, Congress will make up for the tax receipts lost from the ethanol producers by pulling $14 billion over the next ten years from reduced tax breaks and increased royalty payments for oil and gas companies. Do not feel sorry for oil and gas producers. The oil and gas depletion allowance and the deductibility of intangible drilling costs and other little money makers will still remain in place. According to Earth Track, a Boston consulting firm, the oil and gas industry receives tax breaks, subsidies and other benefits totaling about $39 billion a year.

The oil and gas experience should make it clear that government support is a well-established policy strategy to encourage development in the private sector to meet public goals. The nuclear energy industry is also highly subsidized. This means that neither nuclear nor fossil fuel is placed on the market at full price, since both are receiving public support. Indeed, public subsidies for conventional energy sources are, in part why, renewable energy sources do not appear to be economically competitive!

We will leave political discussions of this folly for another day. In this last post in a series on biofuels we look at the financial factors that influence the profitability of ethanol and the other biofuels.

From an investor’s viewpoint, the ethanol tax credit appears to be an important factor in the equation for ethanol producers for at least the next three years, but could easily expire before many of the plants currently in the construction and planning stages have been put into full production. Long-term earnings capacity calculations should probably not rely on the tax credit at all, despite the very skillful and powerful corn lobby that is presently working the halls of Capital Hill.

The other major financial factor for the biofuel producers is the Renewable Energy Credit or REC. A good description is provided by
Clean and Green, a renewal energy technology company. Unlike a tax break the RECs are a non-government subsidy to producers of pollution-free electricity. One REC is earned when 1000 kWh of electricity is generated and placed on the grid. The REC is awarded to the “green” energy producer, which can sell it in the open market much like a by-product. The methanol producers or waste-to-energy producers are most likely to benefit from RECs if the U.S. ever gets around to building a national registry to certify and track the tags.

A more active market for RECs would drive the bottom line of biofuels producers with customers in the power generation business. RECs or Green Tags are certified by Clean and Green as well as
Green-e and the Climate Neutral Network and traded on the Chicago Climate Exchange or other state markets. Regional organizations, such as the Western Governors’ Association, and brokers, such as Virtus Energy in Texas and GreenShift Corp. in New Jersey, have tried valiantly to build active trading in RECs. Nonetheless, trading is shallow and the spreads wide. Prices range from $3.00 to $4.00 in markets driven by regulation and $1.00 for other markets. This is significantly lower than in other economies.

Even if the price of oil move back upward on some exogenous shock, the various tax breaks and subsidies are important in bringing profits to the bottom line for biofuel investors. Thus the train may not be derailed at all, just running local rather than express.

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

No comments: