Once touted as a clean, green way to reduce America's dependence on foreign oil as well as helping reduce greenhouse gas emissions, it's now pretty much conceded by most observers that corn-based ethanol turned out to be a costly detour on the road to energy independence. But despite the disappointing industry track record to date, there still appears to be significant interest in the production of this renewable fuel.

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Bankruptcies Spur Consolidation

Encouraged by government incentives embedded in the 2007 Renewable Fuels Standard (RFS) program, investors poured money into many corn-based ethanol producers. However, soaring corn prices, falling gasoline prices and narrowing margins due to an ethanol glut conspired to put an end to many of these operators.

Over the past six months, at least ten producers including Aventine Renewable (OTC:AVRNQ.PK), VeraSun (OTC:VSUNQ.PK) and subsidiaries of Pacific Ethanol (Nasdaq:PEIX) have landed in bankruptcy. But with a number of ethanol refining assets available at bargain prices, buyers started moving in.

Earlier this year, oil producer Valero Energy (NYSE:VLO) purchased seven of VerSun's plants, and more recently, Green Plains Renewable (Nasdaq:GPRE) picked up two other former VeraSun plants. Surprisingly, Green Plain's stock has more than doubled in the last month despite reporting a first-quarter loss of 38 cents per share. Despite all the disappointments, it would appear that some people still see a future for corn ethanol. While the RFS calls for a production cap of 15 billion gallons a year for corn ethanol starting in 2015, that's still roughly 50% higher than the current U.S. production of just over 10 billion gallons a year.

Ethanol 2.0
By 2022, the RFS calls for total renewable fuel production (mostly ethanol) of 36 billion gallons. With corn-based ethanol capped at just over 40% of that production target, the balance is expected to come from next generation cellulosic ethanol plants utilizing cheaper feedstock such as switchgrass and wood waste. Meeting this target has prompted a pick-up in investment in this emerging technology, primarily by the oil majors.

BP PLC (NYSE:BP), Royal Dutch Shell (NYSE:RDS.B) and Chevron (NYSE:CVX) have all upped their game in this area. BP has committed about $1.5 billion to various projects including a partnership with Du Pont (NYSE:DD) to test the production of biobutanol, an advanced liquid alcohol fuel compatible with existing pipelines and car engines. Large-scale production could begin by 2013 and it could overcome a technical bottleneck experienced with conventional ethanol. Right now about 10% of the gasoline sold in most U.S. states is composed of ethanol.

Recently, the Environmental Protection Agency (EPA) proposed that the blend ratio move to 15%, but that proposal has met resistance from car makers and engine manufacturers who argue that current engine technology cannot handle this higher blend ratio. Tests also show that average fuel economy falls by 5% with a 15% blend rate. (For more, see our Oil And Gas Industry Primer.)

The Bottom Line
The combination of strong government support and rising gasoline prices should ensure that the U.S. ethanol industry will continue to evolve. The next phase of production growth should provide investors with materially better outcomes than were experienced during the corn-based start-up phase. (For more, see Getting A Grip On The Cost Of Gas.)

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