ETHANOL INVESTING: COUNTERPOINT
by Robert Rapier, R-Squared Blogspot June 23, 2006
I hesitate to recommend investments to anyone, so I won't. I won't attempt to argue that in the short term, individual ethanol stocks are going up or down. I have seen too many bad stocks go up on hype, and too many good stocks fall on rumors. But I will make the case that many claims regarding ethanol are overblown, and some are simply fiction. I will also take a look at Pacific Ethanol to show why I think the underlying fundamentals make it a very risky investment.
In the interest of full disclosure, I own no long or short positions in ethanol, and have never directly invested in any ethanol stocks. I do work for an oil company, but have been heavily involved in alternative energy. I strongly support sustainable alternatives, having done my graduate school research on cellulosic ethanol. But I do not consider grain ethanol a sustainable alternative, for reasons I will make clear.
First, I want to address two very common misconceptions about ethanol from a rigorous scientific perspective. The first misconception is that ethanol has the potential to make us energy independent, or to displace significant amounts of foreign oil. The second is that Brazil�s energy independence �miracle� can be replicated in the U.S.
Ethanol�s Potential as an Oil Replacement
According to http://www.ethanol.org/FAQs.htm, ethanol production used 14% of the corn crop in 2005. If the entire 2005 corn crop was converted into ethanol, this would have produced 27.9 billion gallons of ethanol. But this is only the BTU equivalent of 16 billion gallons of crude oil (about 390 million barrels). This equals less than 10% of our current oil imports, but these are only the gross barrels displaced. This is the upper limit for how much oil could currently be displaced by corn ethanol, if the energy inputs into the process were all free, or were supplied by fuel sources (like coal) that can’tbe used as transportation fuel, AND we used the entire corn crop.
However, the energy inputs aren't free. Fossil fuels that can themselves be used as transportation fuels are consumed in significant quantities. So, the only energy �created� is the slight excess that is made during the production process. According to a 2002 USDA report on corn ethanol, �The Energy Balance of Corn Ethanol: An Update�, it takes 77,228 BTUs of fossil fuel inputs (natural gas, gasoline, and diesel) to produce 83,961 BTUs of ethanol. This gives a ratio of ethanol output/fossil fuel inputs of only 1.09. The energy balance is improved by including the BTU value of the byproducts � 14,372 BTUs of animal feed byproducts per gallon of ethanol according to the USDA report. If byproducts are included, the net energy production is 27%. That reduces the net ethanol production potential of the entire 2005 corn crop to 27% of the gross, down to about 105 million barrels. This is equal to about 2% of our total oil imports, or a little over 3% of annual U.S. gasoline consumption if we turned 100% of the corn crop into ethanol. That scenario also assumes that there is a market for all of those byproducts.
What does this mean? There is certainly no point in putting E85 pumps across the country, because the U.S. can’tmake enough ethanol to justify them. Even as grain ethanol production scales up, it will displace less than 2% of U.S. oil imports. The reduction in fossil fuel usage is also next to nothing, because ethanol production is heavily dependent on fossil fuels. Likewise, this means greenhouse gas emissions are reduced by a very modest amount. The Department of Energy recently concluded that E85, the 85% ethanol blend, would reduce greenhouse gas emissions by a mere 4%. That's because ethanol is primarily a recycled fossil fuel, with a very small portion of renewable energy thrown in.
The Brazilian Example
There are some fundamental differences between the U.S. and Brazil that explain Brazil�s energy independence. The first is that Brazil has a far lower per capita demand of energy than does the U.S. According to BP�s recently released �Statistical Review of World Energy 2006�, Brazil consumed 664 million barrels of oil in 2005. With a population of 186 million, annual per capita oil consumption was 3.6 barrels per person. The U.S., on the other hand, consumed 7.5 billion barrels of oil in 2005. With a population of 296 million, annual per capita oil consumption in the U.S. was 25.3 barrels per person � seven times that of Brazil.
On the production side, in 2005 Brazil produced 627 million barrels of oil, for an annual per capita oil production of 3.4 barrels per person. The U.S. produced 2.5 billion barrels of oil in 2005, for an annual per capita oil production of 8.4 barrels per person. The annual shortfall between oil consumption and oil production in Brazil was 0.2 barrels per person in 2005. In the U.S., the shortfall between consumption and production was much larger at 16.9 barrels per person.
The question then arises: �Just how much did widespread use of ethanol in Brazil contribute toward their energy independence?� The answer is: �Not much�. In 2005, Brazil produced 4.8 billion gallons of ethanol, or 114 million barrels. However, a barrel of ethanol contains approximately 3.5 million BTUs, and a barrel of oil contains approximately 6 million BTUs. Therefore, 114 million barrels of ethanol only displaced 67 million barrels of oil, around 10% of Brazil�s oil consumption. In other words, Brazil�s energy independence miracle was 10% ethanol and 90% domestic crude oil production. Brazil did not farm their way to energy independence.
The reason the U.S. should not expect to emulate Brazil�s success becomes clear based on the production/consumption imbalance. If the ethanol produced by Brazil is added to the production side of the equation (0.4 annual barrels of oil equivalents per person), then Brazil�s oil equivalent production number increases to 3.8 barrels per person per year, which is 0.2 barrels greater than their consumption. Therefore, they are independent of imported oil, and even have a slight excess of ethanol to export to countries like the U.S.
However, the situation in the U.S. is quite different. Ethanol production in the U.S. was approximately 4 billion gallons in 2005. This is about 0.2 annual barrels of oil equivalent per person, or about 0.8% of U.S. oil consumption. Brazil had a very small 2005 petroleum production/consumption gap � 0.2 barrels per person per year � that ethanol was able to fill. The U.S., on the other hand, had a 2005 petroleum production/consumption gap of 16.9 barrels per person. This gap is currently filled by oil imports. Again, due to the lower BTU value of ethanol, the U.S. would require 29.0 barrels of ethanol per person per year, or 8.6 billion barrels of ethanol each year to replace all oil imports. This is approximately 90 times the amount of ethanol that is currently produced in the U.S.
What does this tell us? Brazil�s ethanol experience can’tbe extrapolated to the U.S. because of the vastly different consumption numbers in the respective countries. It is simply fiction to suggest that Brazil�s path to energy independence can be followed in the U.S.
Some investors have certainly made money with ethanol stocks. Investors once made money on dot-coms as well. Making money is no indication that the underlying fundamentals are good. Some of those dot-coms still exist today, but many of them had unworkable business models and went bankrupt. I will argue that some ethanol companies are in the same boat.
The U.S. Department of Energy last year commissioned a study on mitigating the effects of a peak in worldwide oil production. This report, commonly referred to as The Hirsch Report, had the following to say about ethanol:
�The market for ethanol derived from biomass is influenced by federal requirements and facilitated by generous federal and state tax subsidies.�
�Ethanol from biomass is currently utilized in the transportation market, not because it is competitive, but because it is mandated and highly subsidized.�
Bill Gates may be investing in ethanol, but Warren Buffett recently had this to say:
�It depends on government policy and a lot of other variables we're not good at predicting. It's also a very hot area for investors right now, and we don't like looking at things that are hot and easy to raise money for. Generally speaking, agricultural processing businesses have not earned high returns on tangible capital. Ethanol could prove an exception, but I'm not sure how you gain a competitive advantage with any particular ethanol plant."
Will the subsidies and mandates continue? An increase in ethanol production from the current 4 billion gallons to 7.5 billion gallons was mandated in the energy bill passed in 2005. However, even now ethanol producers are having difficulty keeping up with the demand created when ethanol recently replaced MTBE as the fuel oxygenate of choice, and ethanol prices are skyrocketing.
Ethanol on the West Coast is currently trading at over $4/gallon, but it is pushing $6/gal on the East Coast. Due to the lower energy content of ethanol, East Coast ethanol is trading at the equivalent of almost $9/gallon gasoline! This is adding significantly to gasoline costs in markets where oxygenates are EPA mandated, and is likely to cause a public outcry for relief. This was the case in California, where Senator Feinstein requested and recently received an oxygenate waiver. In fact, a portion of the statement Senator Feinstein�s office released is revealing:
�The California Air Resource Board (CARB) researched this issue at length and found that ethanol-blended gasoline does not help California meet the goals of the Clean Air Act as it relates to reducing ozone formation, particularly during the summertime, and, in fact, ethanol actually increases the emission of pollutants that cause ozone during the summer months.�
The entire press release can be found here.
East Coast regions under oxygenate mandates can point to the precedent set in California and ask for relief. High ethanol prices will put pressure on the government to roll back some of the mandates. Just as consumers demand relief from high-priced gasoline, so are they likely to demand relief from high-priced and mandated ethanol.
Case Study: Pacific Ethanol
Pacific Ethanol (PEIX) is an interesting case study of ethanol producers. They have yet to produce any ethanol, yet their stock climbed from under $10 a share in early 2005 to over $40 in May 2006, before recently correcting back to the low $20�s. The company�s market cap recently exceeded $1 billion before pulling back. So, is it a $5 stock or a $40 stock? Let's look at some fundamentals, as well as what some others are saying.
Pacific Ethanol is building a pair of plants on the West Coast - one in Madera County, California and one in Boardman, Oregon � and has plans for more. At first glance, there appears to be a good market for ethanol in California. According to information found at Pacific Ethanol�s website, ethanol usage in California increased from 750 million gallons in 2003 to 900 million gallons in 2004. That's because it was being used as an oxygenate replacement for MTBE, which was banned by California in 1999. But with the EPA�s granting of Senator Feinstein�s request for an oxygenate waiver in early 2006, the mandated ethanol market in California disappeared. It is no coincidence that ethanol on the East Coast, where the oxygenate requirement is still in place, is significantly higher than in California, where the requirement was waived. Given the ethanol-related pollution issues mentioned by Senator Feinstein in her press release, it is not clear that Californians will embrace ethanol. The recently passed energy bill will help, but it is not clear how much this will spur ethanol demand in California.
Another factor working against Pacific Ethanol�s success is the ability to secure cheap corn supplies for their plant. According to http://www.ethanol.org/FAQs.htm, an important factor to consider when building an ethanol plant is proximity to corn. Local grain supplies, preferably within 50 miles of the plant, are important for keeping costs down. Yet California produces little corn. In recent years, California�s corn crop amounted to barely over 1% of the corn crop in Iowa (http://www.corn.org/web/uscprod.htm). This makes it likely that PEIX will have to import corn from out of state, driving up production costs. It will probably be cheaper for a producer to produce ethanol in the Corn Belt, and then ship the ethanol to California than it would be to ship the corn there and produce it locally. There is a reason that California is not a hotbed of ethanol activity, despite the fact that Californians consume ethanol. It's too far from the corn, so it is more cost effective to ship in finished ethanol.
Finally, consider the following excerpts from a recent CNN story on Pacific Ethanol:
"There is no valuation that makes any sense at all," said Michael Judd, an analyst at Greenwich Consultants that covers Pacific Ethanol. "This is just a bubble situation." Judd, who has a strong sell rating on Pacific Ethanol, said part of the risk to investing in any ethanol company is that the product, a fuel, is a commodity made from corn, another commodity.
Even Paul Resnik, whose employer Dutton Associates is paid by Pacific Ethanol to cover it, doesn't have a buy rating on the stock. Resnik instead opts for a "hold," saying that while ethanol may be a good investment, "it's not the best kept secret." Resnik also said it's easy for lots of companies to get in on the ethanol game with relatively little technical know-how.
This is not high tech, but this is how companies like PEIX are being valued. It is simply too easy to get into this business, and success is highly dependent on continued government mandates. Maybe someday cellulosic ethanol � the much touted next generation of ethanol technology � will warrant these kinds of valuations. I have great hope for cellulosic ethanol, and believe it can eventually make a contribution. But for now, I don't think the underlying fundamentals warrant the valuations placed on grain ethanol producers � especially those far from corn supplies.
Robert Rapier has a master's degree in chemical engineering, and bachelor's degrees in chemistry and mathematics. He has 15 years of experience in the petrochemicals industry, including experience with cellulose ethanol, gas-to-liquids (GTL), and butanol production. He holds several U.S. and international patents, and is currently employed by a major oil company. Robert maintains an energy blog at http://i-r-squared.blogspot.com/.