Ethanol's Growth Story

The U.S. government has mandated the use of ethanol in gasoline for nearly 30 years, creating what seems like a winning business plan for producers.

But extensive use of ethanol makes economic sense only if oil prices remain high, and the price of a barrel of crude on the New York Mercantile Exchange recently fell below $50, the lowest intra-day price since May 2005, and a decline of about 36% from the record high of $78.40  of  July  2006.

Scott Olson / Getty Images E85 is an ethanol-based motor fuel made from corn and blended with 15 percent gasoline.

“Industry growth has been mainly driven by favorable public policy decisions,” Elif Acar, an analyst at Standard & Poor’s, says in a research report. "Several states mandate adding a 10% blend of ethanol to gasoline … and provide further state-level tax incentives for ethanol use. Some states, especially those in the Midwest where corn is grown, provide incentives for the construction of ethanol facilities as well.”

The short answer: Yes. The ethanol sector has launched two high-profile IPOs -- VeraSun Energy and Aventine Renewable Energy Holdings -- and attracted the attention of Bill Gates, Microsoft’s co-founder, an investor in Pacific Ethanol.

Ethanol got another boost in late January when President Bush once again used the State of the Union address to push energy efficiency and the increased use of alternative fuels. The President called for a 20% reduction in gasoline use in the next ten years, tougher fuel-economy standards and increased mandates for the use of ethanol and other alternative, reflecting the growing interest in conservation and sustainable energy.

“For too long, our nation has been dependent on foreign oil,” Bush said.

High profile political support for support for ethanol, however, is already two-decades old.

In 1979,  the U.S. Congress approved ethanol production subsidies in response to an embargo by the Organization of Petroleum Exporting Countries. Federal subsidies have exceeded $10 billion through 2006. The Clean Air Act of 1990 created additional demand for ethanol by increasing its use as a gasoline additive to replace MTBE, a pollutant.

Blending ethanol with gasoline permits refiners to produce greater quantities of lower octane fuel, cutting production costs. Use of ethanol as an additive increases octane, reduces pollution and increases the volume of available fuel.

Ethanol depends heavily on governmental subsidies and mandates. But government can’t mandate the price of corn and other commodities used to make ethanol and the sector’s profits can be clipped by an increase in the price of corn or the  natural gas used in production a s well as increased transportation costs for raw materials.

David C. Nelson, an analyst at Credit Suisse, recently cut his fiscal year 2008 earnings estimate for Archer Daniels Midland, a major ethanol producer, to $1.69 a share from $2.30, below the consensus estimate of $2.72.

“Our key underlying assumption is that ethanol margins revert toward historic norms near 20 cents a gallon, compared with over 70 cents last quarter,” he says in a research report.

Charlie Neibergall / AP Fields of corn surround the Golden Grain Energy ethanol plant, in Mason City, Iowa. (AP Photo/Charlie Neibergall)

Demand for ethanol is strong and the industry is responding with new plants. This could create another problem for investors: Oversupply and declining prices.

Jack W. Plunkett, founder of Plunkett Research, Ltd., a market research firm based in Houston, says there are now about 101 ethanol plants in the United States and another hundred are planned. Each plant costs an average of $75 million to complete. U.S. production capacity now totals about 5 billion barrels, or about 3.4% of total gasoline consumption.

Ethanol is nothing fancy: It’s an alcohol produced by a distilling process similar to that used to make hard liquor. About 30% of the gasoline sold in the U.S. contains 10% ethanol. Use of E85, a blend containing 85% ethanol, may increase as auto manufacturers produce more vehicles capable of burning the fuel. Ford Motor offers cars and trucks capable of running on E85. General Motors built about 400,000 flex fuel vehicles in 2006.

However, only about 800 of the nation’s 170,000 service stations sold E85 in the middle of 2006 and most are located in the corn-producing regions of the Midwest, Plunkett says.

Brazil is the world’s largest producer of ethanol and it provides a significant amount of fuel used by that nation’s cars. Brazil, active in alternative energy for nearly three decades and moving toward energy independence thanks to new offshore oil discoveries, is a major exporter of ethanol to the U.S. Most of Brazil’s ethanol is made from sugarcane.

Ethanol made from corn and other grains soon may be seen as the first generation of the fuel if new production methods are successful.

“The future of ethanol as a viable, environmentally friendly, cost-effective fuel that can be economically produced without government support may lie in new technologies based on production from cellulose rather than corn,” Plunkett says.

Biomass pile

That includes agricultural waste such as corncobs, wheat husks, stems, stalks and even leaves. The key, Plunkett says, is the use of specially engineered enzymes designed to break the waste material into its component sugars that are then are used to make ethanol.

Major chemical companies are active in the field include Dow Chemical, DuPont and Cargill. Iogen, a Canadian biotechnology company based in Ottawa, develops industrial enzymes and is building production cellulose-based ethanol plants in the United States, Canada and Germany.

Plunkett says other research suggests soybeans may be a good stock for ethanol.

That suggests growth ahead, and government subsidies are almost certain to continue. In  his 2006  State of the Union address, President Bush said:  "America is addicted to oil, which is often imported from unstable parts of the world. The best way to break this addiction is through technology…and we are on the threshold of incredible advances.”

However, S&P’s Acar says long-term financing for most new ethanol plants would continue to be rated in the “highly speculative-grade ‘B’ category.”

Think of the state and federal ethanol subsidies as your tax dollars at work.

© 2009 CNBC, Inc. All Rights Reserved