Back To The Future With Ethanol?

By Stephen D. Simpson, CFA | September 07, 2010 AAA

This has been a hot summer for ethanol. Prices have been on the march for almost all of this year's so-called "driving season", and actually edged ahead of gasoline for a bit, though gasoline is now on top again. Will this move trigger another round of the "fuel of the future" frenzy and a surge in construction and investment, or is this likely to be just another head-fake in what has been an exceptionally difficult market for investors?

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Why The Move Now?

It is often fatuous to look at a move in a commodity's price and spend a lot of time trying to explain it. Nevertheless, "often" does not mean always. In ethanol's case, it is impossible to look at the move in ethanol prices as somehow wholly separate from a major move in corn over the past year. Although corn prices slid a bit in the first half of the year, they have jumped through the summer and stand at levels not seen since 2008.

On top of that, there is a sizable tax credit to companies that blend ethanol with gasoline. That gives blenders like Chevron (NYSE: CVX) and Valero (NYSE: VLO) incentive to keep adding ethanol to the mix - even in the face of higher ethanol prices. Moreover, since the federal government has no apparent desire to lift the protectionist tax policies that punish cheaper ethanol imports from countries like Brazil (where Cosan (NYSE: CZZ) produces cheaper ethanol from sugarcane), U.S. producers do not have to worry about foreign supply soaking up the demand. (For more, see A Sweet Ethanol Deal.)

Who Can Benefit?

The ethanol boom of 2005 and 2006 went south as gasoline prices fell and huge amounts of ethanol distillation capacity came on line. A BusinessWeek article highlighted this phenomenon recently - pointing out that more than a dozen producers filed for bankruptcy over an 18-month period that began in October 2008. Among the survivors, Archer Daniels Midland (NYSE: ADM) and Valero are two of the big dogs, with roughly one-fourth of the U.S. distillation capacity between them. POET LLC is likewise a major player, though it's privately held. Pacific Ethanol (Nasdaq: PEIX) and Green Plains Renewable Energy (Nasdaq: GPRE) are the notable pure plays, with Green Plains a somewhat-distant No.4 in the field behind ADM, Valero and POET.

Investors should remember, though, that this is a two-stage market. Producers like ADM and Green Plains benefit from higher ethanol prices and the blending credit. Other downstream players like ExxonMobil (NYSE: XOM) and BP (NYSE: BP) benefit mostly from the credit, and higher ethanol prices can eat into that benefit.

The Bottom Line

History has shown that playing alternative energy stories is tricky at best. Ethanol, wind, micro-generation and solar have all attracted billions of dollars in shareholder capital and a great deal of enthusiasm, but few enduring winners have emerged. Ultimately, ethanol is a tricky play. Ethanol producers need to be able to pass on higher corn prices through ethanol prices, but ethanol prices are constrained to some extent by uncontrollable factors like gasoline prices, government policy and consumer demand for flex-fuel vehicles.

The best play of all might be the hardest one for individual investors. Farmland has a lot of appealing virtues as an investment, but few options are available for investors outside of direct ownership of rare publicly traded names like Cresud (Nasdaq: CRESY) and investment partnerships for wealthy investors. In the meantime, investors can go with diversified names like ADM or Andersons (Nasdaq: ANDE), or concentrated names like Green Plains. But they should do so with an eye toward the historical volatility of this sector and the extent to which government interference in the markets will determine the outcomes. (For more, see The Future Of Green Technology Investing.)

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