Invest in the biofuels of tomorrow

[peejay 327]

Invest in the biofuels of tomorrow

Ethanol stocks are hot, but if you want to get ahead of the pack, look for companies moving from corn-based ethanol to fuel sources like mesquite from Texas and weeds from India.

By Jim Jubak

The Nov. 7 election has been very, very good to ethanol stocks. They've rallied on the theory that a Democratic House and Senate will put more money into alternative fuels than the Republicans in Washington did.

Archer Daniels Midland (ADM, news, msgs), for example, hit a recent bottom on Election Day and then climbed 6.7% in the next week. And the performance of shares of the agricultural-commodities giant is actually at the lower end of an ethanol pack that racked up gains in that week ranging from 6.1% for Aventine Renewable Energy (AVR, news, msgs) to 10.7% for The Andersons (ANDE, news, msgs).

In the short run, I think the financial markets have got it right. The Democrats in Congress are marginally more likely than their Republican counterparts to throw taxpayer money (ethanol producers get a tax credit of 51 cents a gallon from Washington) at the ethanol sector.

In the long run, though, I think the election is irrelevant to the alternative-fuels sector. Indeed, the excitement over the post-election rally in these shares is a distraction from the ongoing transition to the next generation of biofuel technologies.

If you want to understand where this sector is headed in the long run, pay attention to the strategic moves away from corn-based ethanol announced by the new CEO of Archer Daniels Midland and not to the speculation about how much money will go to what technology in the 2007 energy bill.

Short-term energy outlook

Let's take the short term first. The congressional visionaries that drafted the 2005 energy bill had the audacity to mandate the use of ethanol in motor fuels. Starting with 4 billion gallons in 2006, the target gradually climbed to 7.5 billion gallons by 2012.

Thanks to $70-a-barrel oil, however, investment in ethanol production has far outstripped that target. By the fall of 2006, 106 ethanol plants were in production with a combined capacity of 5.1 billion gallons. That's more than the 2006 target. In addition, another 3.5 billion gallons of capacity is now under construction, which doesn't include projects on the drawing boards or those scheduled to break ground soon. Plants currently in operation and already under construction represent 8.6 billion gallons of capacity, more than the 7.5 billion target set by the 2005 law.

State regulations requiring the use of ethanol and growth in market demand from consumers who want to buy U.S. ethanol rather than foreign oil are likely to keep ethanol demand ahead of supply. But there's nothing like a government guarantee to make investors sleep soundly at night. That's why stocks of ethanol producers have climbed with a shift in Congress toward Democrats, who have put a provision to boost the ethanol target by 6 billion gallons -- almost doubling it by 2012 -- into their 2007 version of a national energy bill. Republicans in Congress had proposed an increase only about half as large.

(Don't kid yourself that this has anything to do with the superior virtue of Democrats to Republicans. Farm states just have more clout with the Democratic leadership than they did in a Republican Congress. Iowa is the country's biggest source of ethanol, and Iowa's Democratic senator, Tom Harkin, is in line to head the Senate Committee on Agriculture, Nutrition and Forestry. He would replace Republican Sen. Saxby Chambliss of Georgia.)

A move away from corn-based ethanol

In the long term, however, I'd rather take my cues from a series of speeches delivered by Patricia Woertz, a veteran of Chevron (CVX, news, msgs) who took over the CEO's office at Archer Daniels Midland in May. What Woertz said boils down to this: Archer Daniels Midland, the biggest corn processor in the world and the U.S. market leader in corn-based ethanol production, intends to maintain its global leadership in biofuels by diversifying away from corn.

The company will invest in Brazil, where it will make ethanol out of sugar, in Indonesia, where it will make biodiesel from palm oil, in Europe, where it is already one of the leading producers of biodiesel from rape seed oil -- and, of course, in the United States, where it will expand its production of ethanol from corn.

Forget about all the scientific and not-so-scientific arguments about the fuel efficiency of corn-based ethanol. The "experts" have concluded that producing ethanol from corn either 1) produces 65% more energy than it uses, according to the U.S. Department of Agriculture; or 2) takes 29% more energy to produce than it returns as a fuel, according to David Pimentel of Cornell University.

And forget about out the arguments over whether, once you add back in all the government subsidies, ethanol is cheaper or more expensive than gasoline to produce.

No, what's really driving the strategy at Archer Daniels Midland and at other bigger players in the sector, such as soybean and seed processing giant Bunge (BG, news, msgs), is the rising price of corn and wheat. What worries companies with decades of experience in the volatile commodities markets like these two is the possibility that the competing demand for corn and wheat for human and animal food will painfully squeeze profit margins for ethanol producers.

Corn prices have already surged to a 10-year high this year. Even the third-largest corn harvest in history has not been enough to prevent a 77% jump in the price of corn in the last year. That's driven up costs at food producers such as PepsiCo (PEP, news, msgs), which uses corn in its snacks and corn sweeteners in its soft drinks, and at food producers such as chicken processor Tyson Foods (TSN, news, msgs). And that has squeezed profits: Every 10-cent increase in the price of a bushel of corn cuts 5 cents a share from Tyson's profit, calculates Credit Suisse.

Commodities traders and commodities buyers are in agreement about the cause of the price increase: increasing demand for corn in the United States (and for wheat in Europe) to produce ethanol, and increasing demand for food caused by global population growth and improvements in the diet. Global demand for food will more than double by 2050, Archer Daniels' Woertz said recently, and at the same time, shortfalls in traditional energy supplies will require greater contributions from alternative fuels.

The debate about whether farmers will be able to keep pace with the increased demand for food and fuel is generating more heat than light right now. A high price for corn has already led U.S. farmers to cut the acreage they devote to wheat -- contributing to this year's wheat shortage -- and they will convert pastures and idle or marginal land to corn when they plant next spring. New seeds, promise the seed companies, will increase yields, as will new fertilizers and pesticides, promise the chemical companies. But the truth is, no one knows how much more production can be cajoled from global corn- and wheat-producing regions. Stockpiles are low even after record harvests, and a drought, like this year's in Australia, can put the lie to any projection.

So a smart biofuels producer, one that believes this energy industry is still in its infancy, will diversify its fuel sources exactly as Archer Daniels Midland has begun to do. And a smaller biofuels producer, such as the Finnish oil refiner Neste Oil (NTOIF, news, msgs), will work to make sure that its need for biofuel feedstocks won't compete with the world's need for food in the future, so Neste Oil is investing in palm oil and other sources of biomass.

The best statement of this that I've found comes from a Neste Oil executive in an interview with London's Financial Times: "The key to biodiesel producers is the diversity of feedstock supply."

Fortunately, just about anything can be turned into a biofuel: Texas mesquite, poisonous Indian atjatropha, Canadian forest waste, U.S. animal fats, Malaysian palm oil. It all, for the moment, is a lot cheaper than corn. And, for the moment, all these sources face less pressure on future prices.

Some of the technologies to produce fuel from these sources aren't as well developed as corn-to-ethanol technologies. But with corn at a 10-year high, you can bet there's a lot of incentive to take these sources from demonstration to mass market as quickly as possible. With market incentives like this, a few hundred million in a congressional energy bill seems, well, more a way to score political points with constituents than a way to meaningfully increase energy supplies.

In the coming months, I'll keep my eyes open for biofuel stocks to recommend to you. Since shares of alternative-fuel companies tend to track the price of oil, and oil prices have been weak lately, I think we investors have time to do our research. If you're looking to build a portfolio in this sector, I'd start by putting a big diversified company such as Archer Daniels or Bunge at the core of my holdings. That will give you an exposure to all the developments in the sector in one or two stocks. But even the shares of these big companies tend to trade with the price of oil, so I'd still urge patience.

http://articles.moneycentral.msn.com/Inves...OfTomorrow.aspx

[Hilarious Clinton 452]

We need more domestic ethanol and less oil from unfriendly sources.

[Ban Hammer 14,271]

We need more domestic ethanol and less oil from unfriendly sources.

as long as you don't mind paying more for less milage, feel free.

[Hilarious Clinton 452]

We need more domestic ethanol and less oil from unfriendly sources.

as long as you don't mind paying more for less milage, feel free.

Ethanol is more expensive now but as the oil price rises the tides will turn. Free market baby.