America’s interest in ethanol as an alternative to petrol may not be based on sensible economics or be all that green, but for investors, opportunity knocks, says Jody Clarke
Anyone sceptical of George Bush’s green credentials should have tuned
into last month’s State of the Union address. In the search for greater energy independence, the man who pulled the US out of the Kyoto Treaty and suggested drilling for oil in the Alaskan wilderness proposed a bolder, greener means of achieving that goal.
He told legislators that the government planned to cut US dependency on oil by 20% by 2017 – mainly through a fivefold increase in the use of clean renewable fuels, such as ethanol. Doing so “will enable us to live our lives less dependent on oil”, he said, and “help us to confront the serious challenge of global climate change”. Why then, has the green lobby remained unconvinced, if not wholly hostile to the plans? Ask one of the 75,000 protesters who took to the streets of Mexico City last week, and you may get your answer. The trouble with Bush’s grand plans for increasing the use of ethanol is that America’s primary source of the clean energy is corn, ie maize. Of America’s corn crop, 20% is now turned over to ethanol production, according to the US Department of Agriculture, from just 3% four years ago.
Unfortunately for Mexico’s poor, that has placed an enormous and sudden demand on a crop that until recently was used primarily as animal feed and to make flour. As a result, corn prices are already up 60%-70% on last year, trading at ten-year highs, which has seen the price of tortillas, made from white corn, almost double in the same time period, to ten pesos a kilo. Tortillas are a staple in Mexico, hence the street protests. But it’s not just Mexico’s poor who are suffering – unless they want to cut back on meat consumption, US consumers as a group will be forced to fork out an extra $1bn for beef this year, compared to 2006, while livestock farmers from Indiana to Nebraska are being driven into debt as the cost of the corn feed they give to their cattle soars.
Is corn ethanol really a green fuel?
Ethanol has been subsidised to some extent by the US government for years, so the side effects of its expansion should have been easy to anticipate. Senator Bill Bradley of New Jersey predicted as much in 1999, when he warned that ethanol subsidies would “have unintended consequences, which is to drive up the price of other commodities as fuel competes with food”. But surely the green pay-off from using ethanol is worth a bit of extra pain for the US consumer? Well, it might be – if there was a pay-off. But unfortunately, ethanol subsidies could cause more environmental harm than the average coal-burning power plant. In a 2006 study, David Pimentel of Cornel University and Tad W. Patzek of the University of Berkeley found that, in terms of energy output, corn-based ethanol actually needs 29% more fossil fuel to make than it produces in equivalent energy. This gives an Energy Return on Energy Investment (EROEI) ratio of about 0.7 to 1 – below break-even point. “I think it’s a scam,” says Pimentel. Even more optimistic studies put the ratio at 3 to 1 at best, says Byron King in The Rude Awakening. The world oil industry, by contrast, is estimated to have an EROEI between
25 to 1 and 30 to 1.
Even if the fuel was more energy-efficient, it could never replace petrol – it wouldn’t come anywhere near. The US currently produces five billion gallons of ethanol a year, accounting for 1% of petroleum use, says Pimentel. “But even if you converted 100% of corn production over to ethanol, it would be equal to 6%-7% of total petroleum use. It’s not going to solve any of our energy problems.” On top of that, Pimentel and Patzek calculate that it takes 8,360 gallons of water to make enough corn to produce ethanol equivalent to one gallon of petrol. At that rate, even if you could grow enough corn, you would need to devote six times the total amount of water currently used in the US each year simply to ethanol production in order for the fuel to replace petrol. And quite apart from the energy and water needed to make it, ethanol is also damaging the environment in a more predictable fashion. Corn production causes more soil erosion and uses more nitrogen fertiliser than any other crop. From the farmlands of the US Midwest, these pollutants flow all the way to the Gulf of Mexico, where they are the primary cause of the ‘dead zone’, an oxygen-depleted stretch of water south of Louisiana that’s almost the size of Belgium. So much for ‘environmentally friendly’.
Is politics fuelling the ethanol boom?
So, given it produces less energy than the fossil fuel needed to produce it, and arguably has a heftier environmental impact, why is the US backing increased production? “It’s money and politics,” says Pimentel. “Big money and politics.”
Throughout the 1970s and 1980s, several politicians championed the use of ethanol as a viable alternative to petroleum. The fact that its most vociferous supporters received donations from ADM, the largest ethanol producer both then and now, is no coincidence. Chief among them was House Majority leader Bob Dole, or “Senator Ethanol” as he was better known among some Washington insiders. Between 1981 and 1994, Dole and his political foundations received $178,000 in contributions from ADM, according to Common Cause, a Washington DC-based watchdog. Shortly after his wife, Elizabeth, took over as head of the Red Cross, the group received $1m from ADM. In return, ADM alone received $150m in subsidies in 1987, while the ethanol industry as a whole has collected $3.5bn in tax credits (at 54 cents a gallon of ethanol, now reduced to 51 cents) since then. Without those subsidies, the ethanol industry would never have been profitable. “Ethanol has been an excellent investment for the firm [ADM],” wrote The New York Times in 1996, “but a rotten investment for the consumer.”
Could Brazil hold the solution?
So is there any hope for ethanol as the clean alternative to petrol? For that, you have to head south. What Bush has been planning for over two years has been perfected over the past 30 years by the Brazilians, who have replaced 40% of their country’s gasoline consumption with ethanol during that time. How? Simple: they don’t use corn.
“Brazil produces ethanol from high-yielding sugar cane in a tropical climate using an agricultural system that is far less dependent on fossil fuel inputs than is the case in the US,” says King. Cane-based ethanol yields about 7,225 litres of ethanol per hectare against 3,750 for corn-based ethanol, while costs are 50% lower than in the US. The resultant fuel is estimated to have an EROEI of about 8 to 1 to 15 to 1. While this isn’t as much as oil on current drilling methods, it’s a bit better than tar sands. Unsurprisingly, the Brazilian government is investing millions in the industry, both for domestic use and exports. It hopes to more than double ethanol exports to $1.3bn by 2010 from $600m now.
This means that if the world begins to turn against biofuels from other sources, Brazil is well placed to benefit. That’s because it is by far the world’s largest exporter of sugar cane, accounting for 20 million of the
150 million tonnes exported around the globe each year. That figure has risen from just 1.5 million in 1990. And at 400 million tonnes, annual cane production is far ahead of its closest rival, Australia, on 35 million. Sweden and Japan are currently negotiating deals with the Brazilian government to import ethanol, and with the EU reforming its sugar market, stripping away the subsidies that have kept its own industry afloat, there is considerable potential for further growth. And there’s room for domestic demand growth too – nearly 70% of new Brazilian car sales were flex-fuel last year (a combination of ethanol and petrol), but that figure will hit 100% by 2011, reckons Resource Investor.
Why the US won’t follow Brazil
But the US has no plans to follow Brazil’s success. Peter Thompson is chairman of Temple Capital Partners and an executive officer at Clean Energy Brazil, which invests in Brazilian sugar mills. He says, “the US is more concerned with corn farmers than with the greenhouse effect” because they form an important group of voters in the Republican heartland of the Midwest. Corn-based ethanol “started off as a means of producing corn to help agricultural communities in the US”, he says; energy security is a recent add-on. The US isn’t worried enough about global warming to let Brazil compete with its own burgeoning ethanol industry: it has placed an import levy of 54 cents a gallon on Brazilian ethanol, which Congress has just voted to extend for another two years.
So although the economics behind corn ethanol may not add up, it seems it will be around for some time to come. What does that mean for investors? On current trends, the US is set to use half of its corn crop for ethanol in the next 18 to 24 months as 77 further ethanol plants come on line to add to the 113 already built. Currently, two-thirds of all grains are used as feed stocks, which means there will be an inevitable impact on the price of soft commodities like livestock, which rely on increasingly costly corn for feed. Mark Mclornan of Agro Terra sees corn prices rising another 300% to 400% over the coming five years. As more US farm land is turned over to corn, that also means less land for other crops. This will have a “spin-off” effect on cotton and soybean prices, says Sudakshina Unnikrishnan, commodities analyst with Barclays Capital, who believes soft-commodity prices in general are on a strong uptrend. “There is definitely going to be market tightness.” We look at some ways to benefit from this in the box on page 24.
How to profit from the ethanol boom
Ethanol might be the fuel behind the boom in corn and soft commodities prices, but one sector you should definitely avoid is the firms that are producing it. As prices for corn have risen, so has the cost of making ethanol, while the actual selling price has fallen in line with oil prices, squeezing ethanol producers’ profit margins.
This has battered the share prices of pure-play ethanol firms such as California-based Pacific Ethanol Inc (PEIX: US) and Aventine Renewable Holdings Inc. (AVR: US) of Illinois. Their share prices are down to $16.40 and $15.69 from highs of $44.50 and $42.50 respectively last year. Another ethanol company, Hawkeye, was forced to postpone its initial public offering in September. Companies maintain that once a breakthrough in cellulosic production – which allows ethanol to be made from a wider range of raw materials – comes through, ethanol companies will be less vulnerable to the corn price.
But as David Pimentel of Cornel University points out, we are nowhere close to reaching a breakthrough. In fact, his research with Tad W. Patzek of the University of Berkeley found that alternatives, such as switch grass, required 45% more fossil fuel than the fuel produced, while wood biomass required 57% more. That’s far worse than corn at 29%.
Investors would be better off looking at ways of playing rising demand for corn, and the knock-on effect to other soft commodities. Until recently, the only way to get direct exposure to soft-commodity prices was through spread-betting – not the most convenient or stable method of investing. Thankfully, there is now an easier way to play the boom: through exchange traded commodities (ETCs). These track the price of a specific commodity or commodity index, and because they are traded on stock exchanges, can be bought as easily as shares through most brokers, while management charges are less than 0.5% a year. Soft ETCs tracking corn, wheat, soybeans, sugar, soybean oil and cotton are all available to investors. Alternatively – and this might be a better bet – if you want to spread your risk across a range of softs, the ETFS Agriculture security (Ticker: AIGA: LN) follows the DJ-AIG Agriculture Sub-Index, which tracks a basket of soft commodities. The allocation is 25% soybeans, 19% corn, 16% wheat, 11% cotton, with the rest being made up of sugar, coffee and soybean oil. For more information, see www.etfsecurities.com.
If you would rather play softs with stocks, you might want to look at agribusiness giant Bunge (BG: US), a long-time MoneyWeek favourite. The group stores and processes soft commodities, including soybeans, and also supplies fertiliser to farmers in Brazil. It recently beat analysts’ expectations for the third quarter in a row as rising crop prices encouraged farmers to grow more, boosting demand for fertiliser, which saw fourth-quarter profits rise by 74% on last year. The group trades on a p/e of 15 for 2008. Another agriculture play is farm machinery manufacturer Deere & Co (DE: US). The group is well placed to benefit as farmers reap the gains from rising crop prices – bigger profits mean more money to invest in machinery. On top of this, the amount of land being farmed in the US may have to grow in coming years to have any hope of meeting ethanol targets. To stop corn stocks falling to zero over the next two years, Credit Suisse analyst David Nelson says the US must turn over 12 million acres of land out of the 36 million held for conservation purposes to increased corn production. More land, of course, means more machinery to work it.
Investors could also look into a more successful biofuel – Brazilian ethanol. Clean Energy Brazil (CEB: LN) listed on Aim in December, and plans to invest in ethanol and sugar mills in the country. It raised £100m in funding, 30% from Invesco and 29.9% from US fund manager Stark. It has already bought a mill for $140m, which has sold forward all its sugar for the next 18 months, says Tom Frost of Numis Securities. The group is focused on Brazil’s domestic ethanol market, and aims to invest in firms with a total of 30 million tonnes of sugar under their control within two years. Executive officer Peter Thompson says, “once you have cane in your hand you have a fully integrated business… under your control”, one that is not subject to fluctuations in the sugar price, unlike most US-based ethanol producers.