With the Middle East still in turmoil and demand surging, oil has once again resumed its skyward climb. Funds like the iPath S&P GSCI Crude Oil ETN (NYSE:OIL) have rallied over the last few weeks as investors looked for ways to profit from the tensions and soaring global demand. Escalating petroleum prices have also led to renewed interest in biofuels. However, while traditional corn and sugarcane ethanol have provoked an intense backlash from both policy makers and the public, second-generation biofuels made from plant wastes or non-food crops, may be the best way to play the sector.
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Cellulosic Producers
As the impassioned debate continues to rage about whether carbon emissions from ethanol production and use are lower than those from oil, or whether the 33% of the U.S. corn crop used in ethanol production actually drives up food prices, second generation biofuels companies are hard at work.

Instead of sugar-based ethanol, these second-generation biofuel companies hope to produce hydrocarbons. These molecules are chemically similar to those that already power planes, trains and automobiles. These "drop-in" fuels won't absorb water like ethanol, nor are they corrosive. They can be put directly into fuel tanks and pumped through pipelines, just like regular traditional oil based fuels. In addition, feed stock costs are next to nil. By using wheat straw, sugar-cane bagasse (the cellulose-rich waste from cane processing), yard trimmings or even trash itself, these companies hope to overcome one of the major hurdles of corn-based ethanol.

The long term outlook for advanced biofuels is interesting. The 2007 Energy Security and Independence Act mandated the use of 36 billion gallons of biofuels annually by 2022. The bill also called for 20 billion gallons of biofuel to be made from lighter environmental foot-printed advanced feed stocks such as cellulosic ethanol or algae. The U.S. Navy has plans that by 2020, over 6 billion liters or about half the fuel it uses a year, will be from renewable sources. With current technologies analysts estimate that cellulosic biofuels are competitive with petroleum when the price of crude oil reaches $120 a barrel, and research conducted by Sandia National Laboratories suggests that nearly 285 billion liters of biofuel a year could be produced from the nation's agriculture without breaking too much sweat. That is roughly equal to about 1.8 billion barrels of crude oil.

Betting on the Drop-Ins
While the advanced biofuels market is still in its infancy, it does offer promise, but investors wanting to participate in second generation fuels need to do their own digging. Here are a few picks.

Europe's largest oil company Royal Dutch Shell (NYSE:RDS.A) has partnered with Codexis (Nasdaq:CDXS) to create enzyme-based technology that will make biofuels from wheat straw and sugar-cane bagasse. This collaboration, along with Cosan (NYSE:CZZ), will build a plant capable of producing 105 million gallons of drop-in fuel every year. Similarly, biotech company Amyris (Nasdaq:AMRS) has partnered with French oil giant Total (NYSE:TOT). Using genetically engineered yeast, the pair hopes to find similar results. These two partnerships represent the two furthest along drop-in fuel producers.

Recently IPO'd Gevo (Nasdaq:GEVO) is planning to make another type of post-ethanol fuel: butanol. By retrofitting existing ethanol plants and companies goal is to produce about 2 billion liters of butanol by 2014 annually.

Annually, the U.S. generates over 250 million tons of municipal solid waste. Much of which is comprised of organic compounds that can be converted into transportation fuels. Privately held Fulcrum BioEnergy has inked deals with both Waste Management (NYSE:WM) and Waste Connections (NYSE:WCN) to provide feed stocks for its new Sierra BioFuels Plant. These kinds of partnerships could mean new future revenue streams for the traditional garbage companies.

Bottom Line
As traditional corn-based ethanol has risen more than a few eyebrows with regards to the "food for fuel" debate, second generation biofuels companies hope to overcome that problem by using innovative feed stocks. While the sector is still in its infancy, early investors could be handsomely rewarded. The previous stocks are a few of the current leaders in the space. (For more, see The Biofuels Debate Heats Up.)

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