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Tickers in this Article: PEIX, VSE, AVR, PBR
It all looked so promising a few months back. As industry pundits were warning that crude oil prices could soon breach the US $100 per barrel level, an alliance of Wall Street financiers, Silicon Valley venture capitalists and Midwestern farmers started putting together a new industry in the U.S. that seemed like a true "win-win" for producers and consumers alike.

In a world increasingly concerned about the effects of global warming and looking for ways to diversify its energy supplies away from the increasingly unstable Middle East, the promise of ethanol, literally a "home grown" source of fuel, looked too good to pass up.

The idea that one could simultaneously reduce America's dependence on foreign sources of energy and restore the prospects of the country's long suffering farm belt enticed many investors.

It prompted a massive inflow of capital into the construction of new ethanol plants designed to convert seemingly abundant supplies of corn from the Heartland into environmentally more benign ethanol fuel for hard-pressed U.S. motorists.

Further incentives fueling the ethanol building boom came when the U.S. government banned the use of MTBE, a potential cancer-causing additive from regular gasoline. As a replacement for MTBE, demand for ethanol soared - and so did its price, reaching almost US $3 a gallon in wholesale markets.

Reacting to all these positive developments, investors and financiers quickly jumped on the bandwagon. Shares in existing producers like Pacific Ethanol (PEIX) took off. From a starting price of around US $10 a share at the beginning of the year, the stock more than quadrupled over the next few months to trade at more than US $42 by mid-May.

Prompted by these elevated valuations, a flurry of IPOs quickly hit the markets. Shares of new ethanol producers VeraSun Energy Corp. (VSE) and Aventine Renewable Energy (AVR) were quickly snapped up by eager investors. It looked like the sky was the limit for the industry.

Then the bottom fell out.

Since hitting their peak valuations in mid-summer, the shares of the ethanol producers have plummeted. Pacific Ethanol shares have lost two-thirds of their value while VeraSun and Aventine are down by more than half. Wholesale ethanol prices are now hovering in the US $1.70 a gallon level.

While the recent dramatic drop in oil and gasoline prices has obviously had a negative effect on ethanol prices, that's only part of the story. Ethanol share prices started heading south long before oil prices started their dramatic dip.

In start-up industry scenarios like ethanol, supply can sometimes run well ahead of demand as the inflow of new capital rapidly boosts capacity. And that's precisely what's happened. The over-build in ethanol capacity is now expected to flood the market with ethanol well into the for-seeable future.

To further aggravate conditions on the supply side, Brazilian state oil company Petrobras (PBR), one of the world's largest ethanol producers, has opened negotiations to sell its sugar-cane based ethanol to the U.S. market. It seems they can make money despite the US $0.54 a gallon tariff wall designed to protect domestic producers. The Brazilian production cost is estimated between US$ 0.87 to $1.10 a gallon compared to approximately US $1.59 a gallon for domestic producers.

While the demand side of the equation for ethanol got an immediate boost due to the removal of MTBE from the market, the longer term future of ethanol hangs on its acceptance as an alternative fuel in its own right.

This could be an uphill battle as consumers are now becoming aware of the fact that a gallon of E85, the standard ethanol blend for cars, provides approximately one-third less mileage than a gallon of unleaded gasoline, due to its lower energy content. This should be reflected in the pump price, otherwise ethanol is no deal for the motorist. If the pump price for regular unleaded gas drops to US$2.25 a gallon, then the mileage equivalent price per gallon for E85 should be US $1.59 – a price equal to the current US domestic production cost. That's what is known as a show-stopper.

Another show-stopper could be potential short-falls in the domestic availability of the primary feedstock, corn. In South Dakota, existing ethanol plants are already claiming half of the state's corn crop and if all the planned plants for Iowa are built, they would gobble up that state's entire crop. Critics wonder if the US could ever produce enough corn to supply the projected ethanol output target of 10% of domestic gasoline demand without having an adverse impact on corn supplies for livestock feed.

Now that reality has set in, investors looking to participate in the ethanol industry need to take a long sober look at the basic economic rationale for this business. Based on current fundamentals, it's not easy being green.

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