Ethanol Will Do More Than Survive

08/25/2011 10:30 am EST

Focus: STOCKS

Corn-based ethanol was America’s silver bullet in the alternative-fuel camp when oil first soared past $100 a barrel, but it’s future holds challenges for many of its players, writes Brendan Coffey of Cabot Wealth Advisory.

Ethanol has been a fuel for automobiles from the start of the industry. In 1896, Henry Ford built his first car, the Quadricycle, to run on ethanol.

His Model T, which revolutionized auto manufacturing when it rolled off the assembly line in 1908, was designed to run on ethanol or gasoline. Even as Ford continued to push for ethanol from corn as the logical fuel, lower priced gasoline won out.

Ethanol made a big run again recently, but when corn prices shot up, people started questioning whether corn’s best use was for fuel. No doubt there was a place for ethanol subsidies at one point, but I think it’s foolish to pay billions of dollars to support a fully developed industry when we’re suffering from a fiscal crisis.

There are many arguable downsides to ethanol supports. Not least is the effect on rising food prices (although other factors like an awful world crop year last year and booming Asian demand for cattle feed are also significant in corn’s price rise too).

Surprisingly, it seems Congress, long the defender of ethanol, is prepping to end the subsidies. Maybe.

In June, various reports indicated that Congress had reached a bipartisan deal to eliminate the subsidies in July, in a bid to narrow the current deficit by a billion or two. True to form, Congress didn’t end up actually doing anything on the deal, opting to go on August vacation instead.

But ethanol industry players expect that Congress will let the subsidies and tariffs expire as scheduled at year’s end. There’s good reason to: Under rising ethanol-blending mandates, it is estimated the subsidies as structured will cost taxpayers $54 billion through 2015.

Don’t bet on it just yet—there was a lot of expectation that Congress would let the subsidies expire last year too.

Setting subsidies aside, there is a strong argument to be made that ethanol’s inclusion in the fuel mix lowers US gasoline demand and therefore gasoline prices. A 2008 University of Iowa study estimated ethanol kept gas prices 20 cents a gallon lower (or more) by lowering gas demand.

Removing the tariffs on imported ethanol should also lower ethanol prices and allow cropland to be used for food—not fuel—easing global food prices in turn. A federal study last year found a net savings in carbon impact versus gasoline (albeit relatively small), which in turn has environmental benefits.

Of course, the uncertainty of subsidies places a big question mark before those looking to invest in the biofuels industry.

Somewhat surprisingly, the major ethanol refiners in the US, Archer Daniels Midland (ADM), Valero (VLO) and The Andersons (ANDE) haven’t suffered much. ADM and The Andersons have actually performed slightly better than the broad market since June (both have notable non-ethanol business lines benefiting from corn’s price strength).

Meanwhile Valero, which is a significant gasoline refiner, has been weaker than the market of late because gasoline refinery maintenance has taken some capacity off line this month.

While each would take a hit from the elimination of ethanol-refining subsidies, they still have the financial heft to stay afloat and meet the growing ethanol-blending mandates that don’t appear to be going away. Earlier this year, the Environmental Protection Agency approved using a 15% ethanol blend in gasoline for cars made in 2001 or after.

NEXT: Biofuel Stocks to Watch

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But younger biofuel stocks haven’t fared nearly as well.

Codexis (CDXS), which makes catalysts for ethanol and biodiesel production and for pharmaceutical production, has fallen from $11 in May to $6 at the beginning of August. Amyris (AMRS) and Gevo (GRVO), which each make renewable substitutes for petroleum-based fuel products, have each fallen 50% since the early spring.

 There is a lot to like about each of the three companies, but they are better watched than bought right now. My suggestion is to wait for the market—and especially oil prices, which hold sway over the business models of alternatives—to find their equilibrium.

If you’re looking to build a watch list of stocks to buy sooner rather than later, I suggest looking at some of the companies that are performing well in Brazil’s robust ethanol market.

As the world’s second-largest ethanol producer after the US, Brazilian producers would benefit from removal of the three-decade old, 54-cent per gallon tariff on ethanol imports. Cosan (CZZ), in particular, is worth taking a closer look at.

Cosan, one of the larger, more established companies in Brazil, was founded in 1936 as a sugar cane producer. In 1976, when Brazil jumped headlong into ethanol production by requiring a blend of up to 22% of ethanol in gasoline, Cosan became one of the leading makers of the fuel.

Today, many Brazilian vehicles can run on pure ethanol, helping cane-based ethanol now command 50% of the auto fuels market in the country. Cosan has expanded with ethanol’s influence, buying up ExxonMobil’s (XOM) retail filling stations business in 2008.

Last year, Cosan entered a 50-50 partnership with Royal Dutch Shell (RDS) in a new company, called Raizen, to produce ethanol, sugar, and power (by burning cane husks) from sugar cane.

In its latest quarter, reported last week, Cosan’s sales grew 25% to 5.19 billion reais (equal to $3.3 billion) with a net profit of 2.3 billion reais ($1.5 billion), although the bulk of that eye-popping net profit came from accounting for the merger of a number of company assets into the Raizen venture. Setting that aside, profit would have been a lot less, at $106 million.

It is Raizen that makes Cosan worth considering. The new company will produce 528 million gallons of cane ethanol a year, 9% of Brazil’s demand, and distribute them through Shell’s retail network in Brazil.

Shell expects the global demand for low-carbon biofuels like ethanol (and cane-based ethanol is believed to have a lower carbon footprint than corn ethanol) to triple worldwide by 2030…and for Raizen to grow with it. Should the ethanol tariffs expire at year’s end, it’s a good bet that a lot of Cosan’s and Shell’s growth will come from exports to the US

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