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"A Research Report on Ethanol Investment: Golden Opportunity or Fool’s Gold?" By Russell Hasan
Introduction: The Ethanol Boom We are strong advocates of alternative energy, and we are happy to see the American ethanol industry growing. But we are also advocates of informed investments and not “irrational exuberance” manufactured by hyperactive investment bankers and a media that goes with the flow. This report is a cautionary note for investors interested in American companies producing ethanol from corn, pointing out various factors and data to consider before risking losses in ethanol investments. The investment banks who led us to the golden pastures of dotcom before 2000 and the subsequent burst bubble are the same that are now leading the charge for corn ethanol. Corn ethanol is projected to be a sure bet for investors, just as dotcom was at one time. We believe that a near-term boom and bust in corn ethanol is possible if the individual investors are not careful. In this report we examine eight points of caution for ethanol investors, after which is a conclusion focusing on the long-term potential of ethanol. 1. Supply and Demand: Ethanol use in gasoline, as a replacement for the toxic gasoline additive MTBE, has been mandated by the government. Several states have also passed ethanol mandates or are considering mandates. Ethanol producers are blessed with extremely generous financial incentives, including a $0.51 of tax exemption on federal excise tax per gallon of ethanol blended with gasoline, a $.10/gal tax credit for “small” producers making less than 60 million gallons, and a $0.54/gal import tariff on ethanol. We have the capacity to produce 4.7 billion gallons annually, with capacity of 2 billion additional gallons under construction, according to the Renewable Fuels Association. By 2012, mandatory ethanol consumption will rise to 7.5 billion gallons per year, required by President Bush’s Energy Policy Act of 2005. If U.S. corn ethanol capacity exceeds 7.5 billion gallons in 2012, prices may decline sharply. If corn ethanol capacity in the near future exceeds the mandatory ethanol consumption levels for the near future, then there will be pressure on ethanol prices much sooner. If the current rate of capacity increase continues, then this scenario will definitely take place. 2. Government Support: The use of ethanol for powering vehicles is not new. Henry Ford designed and built ethanol-powered vehicles almost a hundred years ago. But it did not catch on, and there was little attention paid to ethanol in the middle of the 20th century, when gasoline prices were acceptable. Following the OPEC oil crisis of the 1970s, President Carter offered a $0.40 per gallon tax incentive and engineered the first ethanol boom. The ethanol industry unfortunately fell apart with the collapse of crude oil prices in 1986. It can be argued that high oil prices are driving the recent interest in ethanol, and if oil prices go down significantly, due to factors involving oil producers and beyond the control of the ethanol industry, political support for mandates, tax cuts and tariffs may dissipate. If this government support were removed it would put a major damper on ethanol profit margins. Much of Carter’s rhetoric about the need for energy independence is similar to recent speeches by President Bush. If the political concern for alternative energy of the Carter era could fade away, it is conceivable for current political interest to fade as well. 3. Competition from Gasoline: Ethanol offers the promise of domestic energy independence, but it must be able to compete with gasoline to have long-term profitability. It must also be mentioned that ethanol is at a disadvantage compared to gasoline in mile-per-gallon fuel efficiency. According to fueleconomy.gov, a car that gets 16 miles-per-gallon on gas will get only 12 miles on E85. It was also recently reported that the wholesale price of ethanol “was around $3 per gallon compared with about $2.28 for gasoline (before being mixed with ethanol).” Even with GM and Ford having made announcements about producing more flex-fuel cars capable of running on E85, and with more gas stations offering E85, it is questionable whether motorists will find E85 economically justifiable. 4. South American Imports: Brazil, a major player in ethanol, now accounts for more than 50% of the 20,000 barrels/day of U.S. ethanol imports. Brazilian production costs have been 40-50% lower than the U.S., according to a Congressional Research Service Report for Congress of 2005. It may be as low as 20% now. Even with the supposedly prohibitive tariff, which violates WTO rules, Brazilian sugarcane ethanol is competitive with domestic corn ethanol. Brazilian exports to the U.S. are limited only by its capacity constraints. Japan plans to invest $1.29 billion in Brazil towards the production of sugarcane ethanol and biodiesel, which will increase Brazilian ethanol capacity significantly before the end of the decade. Caribbean and CAFTA countries, because of the duty free access provided by the Caribbean Basin Initiative and CAFTA, have been long time exporters of ethanol to the U.S. CBI and CAFTA allow Caribbean and Central American countries to purchase ethanol from other countries such as Brazil, reprocess it, and export to the U.S. without paying the import tariff. It is questionable whether America can champion globalization and keep the ethanol import tariff indefinitely. It is also a matter of time before Brazilian ethanol finds its way to the U.S. via the Caribbean. Brazilian sugarcane ethanol is more energy efficient than American corn ethanol and cheaper than gasoline. By 2010, Brazil will export 2.5 billion gallons of ethanol, which is likely to put enormous pressure on domestic ethanol. Thus, competition from Brazil and the Caribbean may lower the price of ethanol in America in five years. 5. Corn Supply: Corn, a perennial surplus commodity, is now in tight supply because of ethanol. As with all agricultural commodities, corn prices are affected by weather conditions. Ten years ago, for example, corn prices had reached $4.70/bushel, approximately twice the price today. That year had seen a 25% drop in the production of ethanol. The secular long-term tightness of corn is expected to continue for some time. China, a traditional exporter of corn, has now become a net importer. No one knows how severely China will impact corn prices. Of the 11.1 billion bushels produced in the U.S., the ethanol industry consumed an estimated 1.6 billion bushels or 14% in 2005. Corn production is estimated to be 10.5 billion bushels this year with ethanol industry usage projected to rise above 20%. Export markets, poultry and livestock industries will be adversely affected. Poultry prices may rise sharply. The corn ethanol industry will be vulnerable to long-term supply of its raw material, corn. The near term outlook of corn supply does not appear to be assured. USDA reported corn stocks of 3.8 billion bushels as of March 1st. During the Dec-Feb quarter, consumption of corn did not go down as much as was expected due to the higher prices. Worldwatch Institute cautions that “if U.S. corn use and exports were to continue at the same rate in the months ahead as during the December-February period, U.S. corn stocks would be totally depleted by July 28th – roughly 2 months before the next harvest begins.” The demand for corn ethanol is inelastic at present and hence the ethanol industry will be able to cope with likely higher prices. However, lower margins and complaints about possible higher poultry and livestock prices may bring the corn ethanol enthusiasts down to Earth before fall this year. Alan Greenspan recently testified before Congress saying that he has doubts about corn supplies being sufficient for corn ethanol to replace gasoline. If he is right, and the above factors affect corn supplies, then there will not be enough corn to make large-scale ethanol production viable. Ethanol cannot be shipped by pipeline. It has to be barged and trucked. As such, bigger producers may not have an inherent advantage over smaller ones. Many small producers are owned by corn producers’ co-ops. During periods of tight corn supply, small co-ops may do better than larger companies without captive corn supply. There is also a tax break that benefits only small ethanol producers, further making smaller producers preferable to larger ones. 6. Cellulosic Ethanol: Cellulosic ethanol, whose large-scale commercial production is probably at least five years away, will dominate ethanol in the future. There is a Canadian company already producing 260,000 gallons per year of cellulosic ethanol. Several companies working to perfect enzymes for cellulosic ethanol production claim to be close to perfection. Cellulosic ethanol can be produced from straw, switch-grass, short maturity super trees, and biowaste. Curiously, cellulosic ethanol has been unfairly criticized recently as requiring more energy to produce than it yields. Only one process, acid hydrolysis, requires more energy. Current research is concentrated on several other processes which are expected to be the least energy consuming of all kinds of ethanol production. (Corn ethanol has also been criticized as requiring more energy than it yields, but a majority of studies dispute this claim.) The Department of Energy’s Energy Efficiency and Renewable Energy (EERE) office claims that “in terms of key energy and environmental benefits, … cornstarch ethanol clearly outpaces petroleum-based fuels, and that tomorrow’s cellulose-based ethanol would do even better.” They also say that while “corn ethanol reduces (greenhouse gas) emissions by 18% to 29%; cellulosic ethanol offers an even greater benefit, with an 85% reduction in GHG emissions.” A Natural Resources Defense Council-commissioned paper in “Environmental Science and Technology” claims that 1 unit of fossil fuel energy produces 1.3 units of ethanol energy, while 1 unit of fossil fuel may create 6 units of cellulosic ethanol energy, meaning that cellulosic ethanol might be almost six times more efficient. Nathan Glasgow and Lena Hansen of Rocky Mountain Institute report that “while corn-based ethanol reduces carbon emissions by about 20 percent below gasoline, cellulosic ethanol is predicted to be carbon-neutral, or possibly even net-carbon-negative.” In his Congressional testimony Greenspan claimed that cellulosic ethanol held more promise than corn ethanol. It has also been claimed that the byproducts of the process of creating cellulosic ethanol can be burned to power the process, making it more oil-independent than corn ethanol. The previously mentioned Canadian company is seeking loan guarantees from the Department of Energy to help build a cellulosic ethanol production facility in the United States, specifically in Idaho. Still, for the time being the vast majority of American ethanol producers are making corn-based ethanol, which will not compete favorably with cellulosic ethanol in the long term. The ability of U.S. producers to make the switch from corn to cellulose in the future is hard to predict. 7. The Price of Oil: The world is running out of crude oil and this is shaping up to be the decade for alternative energy initiatives. The transfer from MTBE made corn ethanol the first to come out of the gate. There is enormous short-term upside – driven by the same people who brought us the dotcom boom and bust. Ethanol stocks now follow the daily ups and downs of oil prices. Crude oil, volatile as it is, has been nonetheless trading within a narrow range. Ethanol stocks following crude oil has been a zero sum game. It is questionable whether there is gain from this. It is also possible that at the first sign of crude oil price softening, “big money” will get out of ethanol investments. This in turn could reduce political support for ethanol, in which case the farm state Senators may not be sufficient to maintain the ethanol tariffs and tax breaks. We have taken the political stand of advocating the continuation of the ethanol incentives, both for the sake of investors and because domestic ethanol promotes American energy independence and reduces polluting emissions. However, if the incentives are removed, which some politicians want, American ethanol companies will face shrinking profit margins. 8. Celebrity Endorsements: Ethanol has almost reached tabloid stardom. We are inundated with stories about celebrity endorsements of ethanol. For example, many of us have read about Richard Branson’s dinner with Ted Turner at which ethanol was discussed. It is worth noting that cellulosic ethanol was discussed at that dinner. Ethanol stocks got a boost when Bill Gates invested $78 million in an ethanol company. What is little discussed is that he purchased preference shares at roughly 50% of the price of common stock, making this a smart investment regardless of the price of ethanol. Big names involved in ethanol may distract investors from the hard data of the ethanol industry. Conclusion: Cautious Optimism It is our firmly held belief that the next great fortunes are going to be made in the alternative energy industry. Unfortunately, corn ethanol is not a simple opportunity of this kind, for the reasons described above. Although this industry may be profitable for the next five years, it is highly probable that the American corn ethanol industry, except possibly for small co-ops, will face strong pressure from corn supply concerns, sugarcane ethanol imports from Brazil, and new cellulosic ethanol technology in five to ten years. Competition from gasoline will be brutal if oil prices fall, and profit margins will suffer fatal blows if government incentives like the tariff are removed. Companies overwhelmed by these factors will probably cause the ethanol bubble to burst by the end of the decade. Hopefully, the major American ethanol producers will find ways to weather this storm, particularly by exploiting new cellulosic technologies or securing cheap corn supplies, in order to achieve long-term profitability. We are pro-ethanol and we believe that investment in the ethanol industry is necessary to grow capacity to promote the environment and to secure our energy independence. Clean energy is necessary to prevent global warming, and energy independence will free us from reliance upon politically unstable foreign oil. As such, ethanol has a value that cannot be defined in dollars and cents, and it deserves our support. It is also clear that certain factors, such as government initiatives and high oil prices, make ethanol an attractive investment in an industry with strong growth potential. However, investments in ethanol should be based upon statistical data from specific companies, including stability of raw material supply, manufacturing cost, competition, and other market conditions, as well as each company’s long-term plans, rather than investing in ethanol because of its surge in media popularity. In other words, investors should seek good long-term investment opportunities in ethanol rather than short-term investments which may lose money if the factors mentioned above cause the short-term ethanol bubble to burst, but leave ethanol producers’ long-term prospects optimistic. There are opportunities for companies able to secure corn supply and exploit government incentives to remain competitive, particularly if demand is strong and oil prices remain high. However, the major long-term opportunities are with cellulosic ethanol. We hope that American ethanol companies can find a way to be on the cutting edge of ethanol technology in order to achieve strong long-term stability. Going back to the analogy of the dotcom bubble, many dotcom companies that were overpriced collapsed when the bubble burst, but the better companies survived and are still interesting for investors to this day. The ethanol industry may follow a similar path, meaning that the investors who buy fool’s gold will suffer losses, but there are still golden opportunities for smart investors. |