The science behind ethanol-powered vehicles works. It's the fiscal aspects - in the United States anyway - that don't quite add up. And, though the industry's U.S. players caught a break earlier this week when the Senate failed to repeal the oft-debated subsidy that's keeping it domestically viable, the proverbial writing may be on the wall for ethanol.

TUTORIAL: Risk and Diversification

In simplest terms, Green Plains Renewable Energy, Inc. (Nasdaq:GPRE), BioFuel Energy Corp. (Nasdaq:BIOF), and Pacific Ethanol, Inc. (Nasdaq:PEIX) have at least the rest of the year to enjoy the benefits of the Volumetric Ethanol Excise Tax Credit, or VEETC. The tax credit essentially pays oil refiners 45 cents per gallon to blend a small amount of ethanol with a gallon of conventional, petroleum-based gasoline. It's effectively free money, not to mention the law. So, of course it's not tough to coax oil refiners to do the blending.

That free money is also a large part of the reason why the likes of BioFuel Energy, Pacific Ethanol, and Green Plains Renewable Energy have remained viable in the face of much criticism, from government spending hawks to environmentalists to humanitarians looking to make sure food is equitably available to all.

While Senator Tom Coburn's proposal to immediately axe the tax credit ultimately failed, the 40 to 59 vote was an unconvincing one that could go the other way the next time around. Both the Democratic and Republican parties each pretty well split their votes on the matter too, suggesting the idea of ending the credits itself may have merit - the Coburn proposal may have just been a wrong time/wrong way scenario. Indeed, the tone in Washington on ethanol is moving away from "how can we support ethanol?" and toward "how can we politically survive cutting ethanol's tax breaks?" which is not an encouraging sign.

To Make Matters Worse for U.S. Ethanol
As if the cancellation of the VEETC credit wouldn't crimp the domestic ethanol industry enough, there was another less-recognized detail in the Coburn proposal that called for ending the 54-cents-per-gallon tariff on ethanol imported into the United States.

More expensive domestic ethanol, side-by-side with cheaper foreign ethanol? Again, though the Coburn amendment failed this week, the mixed vote and highly-debated issue is likely to mean the import tariff is on the way to being wiped away later.

That's good news for Brazil's Cosan Limited (NYSE:CZZ), or even Royal Dutch Shell plc (NYSE:RDA-A).

Cosan Limited is one of Brazil's biggest ethanol producers. Though weather issues have prompted the country's government to slow ethanol exports this year so far, that spigot could be turned on as quickly as weather patterns change. And, if the United States' import tariff goes away by 2012, a couple of key positives would line up all at the right time for Cosan.

As for Royal Dutch Shell, it's an indirect play on Cosan. The two companies recently entered a $12 billion joint venture (called Raizen) that will pair part of Shell's distribution network of filling stations with Cosan's ability to produce cost-competitive ethanol. Though the deal was targeting European and Asian markets when originally inked in February, one can't help but wonder if Raizen is waiting in the wings for the 54-cent-per-gallon U.S. tariff to go away.

The Bottom Line - Be Ready
It's rarely wise to make an investment based on assumptions of what the federal government may or may not do. On the other hand, ethanol's critics are growing in number, and fervor.

While Cosan and Petrobras (NYSE:PBR) - another of Brazil's big ethanol producers - are the most ready to ramp up ethanol production to export to the United States, a repeal of the tariff and subsidy will likely draw other foreign companies out of the woodwork now that selling to the U.S. could make fiscal sense. Indeed, many of Brazil's smaller ethanol names have already been bought out or co-ventured with some pretty big oil names. Any of those entities or comparable ventures could make headway in the U.S. ethanol market. See, while the blending subsidy may be on its last leg, the mandates that require ethanol's usage aren't under the same fire.

One thing is clear, though, if the subsidy is finally voted out, the impact on these respective ethanol stocks would be nearly immediate. And once repealed, it's not likely a new subsidy or tariff would be introduced. (For related reading, also take a look at Investing In Brazil.)

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Tickers in this Article: PBR, GPRE, BIOF, PEIX, CZZ, RDA-A

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