Ethanol Investment Research

Unless you’ve been living in a cave for the past few years, you’ve probably noticed the extra attention the energy sector is getting. Here at The Sleuth, we recognized how small alternative energy ventures could benefit from the pressures of finding a cure for America’s expensive oil addiction.

With this in mind, I decided to publish an alternative energy guide outlining the benefits and setbacks related to ethanol. The information has been compiled from a series of published Sleuth columns and other research I conducted in Spring/Summer 2006. Some of the ideas were updated for this essay, and I will continue to update the information presented here as necessary.

Select small-cap securities working in the alternative energy sector are also listed in this report. While no direct recommendation was ever made to purchase shares of these stocks, updates on share prices and pertinent news will be added on a regular basis.

It is also important to recognize the volatility of many of these small securities. In April 2006, a wave of media attention and higher gas prices drove up the share prices of many of these companies. Since the hysteria has died down, share prices have settled back to more reasonable levels in most cases.

I never encouraged readers to attempt to time the market when it comes to these stocks, and I still do not recommend this strategy. Attempting this could lead to catastrophic losses. If you determine one of the securities mentioned worth purchasing, expect to hold for a few years before it realizes its true value.

Remember, the “alternative energy age” is still in its infancy. It will be some time before the world will see how these ideas play out as far as practicality and profit are concerned. Research thoroughly and be patient — then you will be rewarded.

The Wall Street Journal featured ethanol on the front cover last week. Here at home, the Baltimore Sun touted ethanol as an “emerging energy star.” Even our president called in an interview earlier this year for the U.S. “to not only advance that technology of deriving fuel from corn, but also deriving fuel from waste materials.”

That’s bold talk for a one-time oilman, but it is becoming more and more apparent that alternatives to the traditional barrel of crude will have to become more prevalent in this age of political tension and dwindling natural resources.

Ethanol Investment Research: A Corn Farmer’s Best Friend

Ethanol is made from the sugar of corn or sugarcane — and is basically grain alcohol that can be mixed in varying amounts into gasoline.  Brazil has successfully reduced 40% of its oil demand by using ethanol fuels and ethanol-burning vehicles.

And it has made its way into the United States as well, with special thanks due to new government mandates.

The U.S. Energy Policy Act of 2005 required that ethanol production increase to 7.5 billion gallons a year by 2012. (Right now, production is at 4 billion gallons annually.) And some local jurisdictions are jumping ahead with their own ethanol laws.

Take Hawaii, for instance — a state that has passed a law requiring 85% of all its gas to contain at least 10 percent ethanol by next month. According to the Associated Press, some companies don’t think they can make the transition by the deadline set for April 2: “The would-be producers say they are a year or more away from having production facilities in place… Oil companies in Hawaii are importing ethanol in order to meet the April 2 deadline.”

In other states — especially in corn country — news of new ethanol facilities seems to come out every week.

Once total funding is secured, the Southeast Missourian reports that a new ethanol plant could be constructed as early as this year…and it’s not the region’s first facility. The plant would produce 100 million gallons of ethanol a year:

“Construction of a second new ethanol plant in Southeast Missouri could start as early as this summer on more than 100 acres along Nash Road and be fully operational 18 months later, officials said Wednesday…

“The news on Danforth’s plant comes just four months after Bootheel Agri-Energy LLC, headed by Chaffee farmer David Herbst, announced its intentions to build a $175 million plant near Sikeston to manufacture 100 million gallons of ethanol per year.”

Same goes for North Dakota’s corn country. From the Associated Press:

“Two companies plan to build North Dakota’s largest ethanol factory here in southeastern North Dakota’s corn country, with construction beginning late this summer. Officials of Gold Energy LLC of Wahpeton and US BioEnergy Corp., which is based in Brookings, S.D., announced the project Wednesday. The plant will cost about $145 million to construct, and will be designed to produce 100 million gallons of ethanol annually.”

Ethanol Investment Research: A Growing Trend

This is happening all over the country: Wherever corn is being grown, there is talk of ethanol. Governments will begin mandating its use and it could be the rehab program our oil addiction so desperately needs.

And with bio-fuels in such strong demand, small producers are bound to get their share of the business. The government is even helping the small-cap company along in this case, offering a “small producer biodiesel and ethanol credit.”

This credit will benefit small biodiesel producers by giving them a 10-cent per gallon tax credit for up to 15 million gallons of agri-biodiesel produced. In addition, the limit on production capacity for small ethanol producers increased from 30 million to 60 million gallons. This is effective until the end of 2008.

Even gas stations themselves are being thrown incentives. Gas stations are eligible for a 30% credit for the cost of installing clean-fuel equipment, like E-85 ethanol pumping stations, effective through December 31, 2010. According the U.S. Department of Energy, a clean fuel is “any fuel that consists of at least 85% ethanol, natural gas, compressed natural gas, liquefied natural gas, liquefied petroleum gas, or hydrogen and any mixture of diesel fuel and biodiesel containing at least 20% biodiesel.”

Ethanol Investment Research: Relevant Companies – First Reported March 20, 2006/ Updated Sept. 2006

1.02Diesel Corporation (AMEX: OTD) Recent price: $1.05; 52-week high: $2.97.

02Diesel develops additive products that help fuels burn cleaner by adding ethanol. 02Diesel’s main product is called O2D05 — a fuel additive that can be made from soybean oil, vegetable oil or animal fats. It is designed to stabilize blending of fuel grade ethanol with diesel fuel, with the end result being a clean burning fuel called 02Diesel.

Possibly even more important to 02Diesel’s business is its ties to Brazil — a country that has successfully reduced 40% of its oil demand by using ethanol fuels and ethanol-burning vehicles. In 2004, 02Diesel began operations in Brazil through its 75%-owned subsidiary, O2Diesel Químicos Ltda.

O2Diesel is finding new markets for its additives, shipping its first bulk order to Australia. Alan Rae, CEO of O2Diesel, said in a statement that “many of our early adoptive partners have eclipsed the one-year anniversary since switching to O2Diesel’s fuel,” thus building credibility of O2Diesel’s additive as a viable alternative.

2.Pacific Ethanol Inc. (NASDAQ: PEIX) Recent price: $18; 52-week high: $44.50.

Pacific Ethanol makes corn-based ethanol, and also sells products generated from the manufacture of ethanol, such as grain and carbon dioxide.

Shares of Pacific took a big hit in the spring after the company signed off on the sale of 5.5 million shares of the stock totaling $145 million. Pacific Ethanol will use the cash to speed up work on five ethanol production facilities.

3.MGP Ingredients Inc. (NASDAQ: MGPI) Market cap: $236 million; share price: $14.40; 52-week high: $19.22.

MGP Ingredients distills wheat starches and wheat proteins for wheat starches and vital wheat gluten and mill feeds. The company makes alcohol used in beverages and industrial alcohol — like ethanol. Like Pacific, MGP also deals in the grain and carbon dioxide byproducts of its distillery operations.

MGP reported net income of $2.1 million ($0.12 per share) for its most recent quarter — up from the $1.6 million ($0.10 per share) reported a year ago. Despite this growth, MGP did not meet analyst’s expectations, which were set at $0.14 a share.

And while revenue was up 12% to $79.4 million, distillery products sales grew 22% percent to $10.2 million, according to the Associated Press.

And MGP’s management has said it expects the company will charge higher prices for its products while paying lower prices for natural gas during the next quarter. Because of this, they are expecting operating income totaling at least as much as during the previous three quarters combined. Talk about a serious growth opportunity…

Ethanol Investment Research:Small-Caps Could Solve the Ethanol Dilemma

The companies that will make the big bucks in the ethanol business will be the ones that succeed in three innovations…more on that in a minute.

The cost to actually make and transport the ethanol is where it gets hairy. I’ve seen literally hundreds of scenarios, some saying that it costs the equivalent of three barrels of ethanol to make just one barrel of the fuel.

But ethanol proponents have made the argument that there are more costs associated with gasoline production than with ethanol. Some ethanol freaks will argue the “true cost” of a gallon of gas…one telling it would be more accurate to assume prices to be around $5 a gallon (that is, if you choose to include things like the money it takes to support the military forces that are protecting our overseas oil supplies).

And location is also creating problems in the ethanol world. Ethanol’s main ingredient — corn — is plentiful in the rural Midwest, but not so much in the populated coastal areas of the country.

Think about it this way: the population of North Dakota is about 640,000 people, whereas the population of the Washington D.C. area (including the Maryland and Virginia suburbs) is almost six million. So an ethanol plant in North Dakota’s corn country would have to be able to get its product to the relatively corn-free capital.

This feat would be simple if the ethanol-gasoline mixture could be piped straight from the refinery to the populated East Coast like pure gasoline. But an ethanol-gasoline mixture can’t be piped, because the two ingredients separate, which could cause the fuel to damage a car’s engine. Ethanol has to be transported by rail, a much more costly endeavor than sending it through a pipe.

More on that from MSNBC:

“‘Corn is in the center of the country and gasoline consumers are on the coasts,’ he [Dr. Darren Hudson, a professor of agricultural economics at Mississippi State University] said. ‘So transportation costs can be quite high — roughly double the cost of shipping gasoline’ or about $1.20 per gallon of ethanol.”

Then there’s the ongoing problem with “reformulated gasoline” — required in some areas that have strict clean air standards. There is a cheaper additive, called MBTE, which has been widely used, and even required in some states (Maryland used MTBE for years). But as it turned out, gas companies found that MTBE had the ability to creep through underground gas tanks into the groundwater. Some have tried to link MTBE with cancer, especially in rural areas where residents rely on well water. So much for cleaner air…

And the EPA has already recommended that MTBE be phased out nationally…and a buyout is in the works which will pay oil companies and refiners some $1.75 billion to phase out production — further cementing ethanol’s fate as MTBE’s replacement.

MSNBC reports that reformulated gasoline is required in nine major metropolitan areas with the worst ozone air pollution problems and in other areas that have voluntarily chosen to use the fuel — this will be a huge market.

Ethanol Investment Research: An Alternative Energy Solutions

Small ethanol companies can eventually solve these problems by developing cheaper and more transportable blends of ethanol fuels, and investors who recognize their achievements early will reap the rewards. Here’s what to look for:

1. The most obvious of the three: Look for a company that can make ethanol cheaper than the 3-to-1 ratio mentioned earlier through a new or improved process. This could include using a mix of products, like ethanol from corn along with a  bioethanol made from various waste products. There will always be a cost argument associated with ethanol, but the main argument for its implementation is to reduce dependence on foreign oil. So making the fuel on the cheap is an added bonus — and one that will naturally the ethanol producers the most customers.

2. Solving the transportation dilemma should be right up some small-cap chemical company’s alley. Finding an economic way to transport an ethanol-gasoline mixture through a pipeline will be a huge breakthrough — whether through a special chemical additive or an improved blending/manufacturing process. This would naturally solve the price argument as well by eliminating a majority of the transportation costs. If you find a company that can do this, you’ve found a winner.

3. Create a cleaner-burning ethanol blend. A company needs to come along that can silence the critics and cement ethanol as the only option for MTBE replacement. Ethanol reduces a lot of emissions, but Dr. Hudson noted that if it does not burn properly, burning the fuel can increase nitrous oxides. Again, this is something that could be within reach for a small-cap chemical or ethanol company over the next few years.

There’s no question that the ethanol market is growing leaps and bounds. And as with any new trend in business, the ones that innovate and stay ahead of the game are the ones that see success year after year.

Ethanol Investment Research: Reader Comments

So far, I’ve heard from ethanol advocates, the anti-ethanol/biofuels crowd and some very inquisitive (and maybe brilliant) skeptics. So without further adieu, I’m going to jump into the mailbag headfirst to help answer some of your questions and talk about some companies involved in the ethanol business:

“Please note that ethanol made from corn is anything but ‘green.’ the pesticides and oil-based substances used to grow corn are draining [the] south and killing the Gulf. Corn is a disaster.”
— Anonymous

As I mentioned last week, ethanol proponents will argue the “true cost” of a gallon of conventional gasoline, which could even include the soldier protecting the oil field. And on the other hand, what additional costs are involved in corn-based ethanol production? Pesticides and fertilizers, to name a couple…

Here is an excerpt from an article posted by the Sustainable Products Corporation: “But what’s missing in this debate is a real understanding of the true environmental costs of how we manufacture products of all kinds. Take ethanol, for example. Closer examination of ethanol production reveals that the manufacture of pesticides, herbicides and fertilizers used to grow conventional corn to make ethanol create almost as much pollution as the MTBE it replaces. In other words, the things that go into making a ‘clean’ product can be horribly polluting.”

But for every problem, there could eventually be a solution, or at least a compromise…

“The company I am writing about is indirectly related to ethanol production. The company name is Startech Environmental Corp. (STHK: OTC BB) and its primary technology is a plasma converter system that was developed to essentially rip hazardous waste apart down to the elemental level. It is able to handle such things as: medical waste, outdated pharmaceuticals, PCBs, chemical agents, hazardous incinerator ash, Various biological wastes, sludge, paints and solvents, electronic industry waste, contaminated soils, asbestos, etc. It doesn’t break things down beyond the atomic level, so it is not a solution for radioactive waste.

“You are probably wondering what this has to do with ethanol. Using the plasma converter system to destroy unwanted waste produces large amounts of hydrogen as a byproduct. In fact, enough is produced that this process produces more energy than is consumed. This hydrogen can be used as is for fuel cells or can be converted to methanol, ethanol, etc. for use in internal combustion engines. The company has completed the research phase on its technology; it is my understanding that they are now moving forward to begin construction. They have contracts with several other corporations for installation of plasma converters. I believe as they move forward, we will find that this provides a solution for several problems at the same time.” — David

I think something like this could solve Anonymous’ problem with pesticides and corn. When people say “waste to energy,” you probably think of those nasty incinerators that burn your town’s garbage when the landfills become full. Basically, it’s a system that solves one problem (too much trash) with another (air pollution).

But this plasma converter seems to bring the basic idea of waste to energy to the next level. And a system that can create ethanol without using sugarcane, beets, corn or any other plant may be a more viable source of energy with fewer “hidden costs” like pesticides and land use.

“In response to your article regarding alternative energy companies, perhaps a back door play on ethanol can be found in Illovo Sugar (trades on the pink sheets as ILVOF.PK).”
— Anonymous

We’re seeing the price of sugar rise along with the popularity of ethanol…and this is no coincidence.

Here is an excerpt from a Jon Markman column on MSN Money: “The great thing about sugar cane as an energy source is that it is incredibly efficient. Many ethanol feed stocks — such as corn, wheat and beets, which are widely grown in the United States — require as much energy to grow and refine as they actually produce in energy. But sugar cane production actually results in a huge net positive energy gain — about 8:1 energy output to energy input. That’s especially so when it’s grown in the country in which it is used, so there is no energy or cost expended in transportation across oceans.”

Brazil has benefited from its multiple growing seasons and sugar production and has successfully converted to ethanol fuels. About 40% of all the fuel sold in Brazil is ethanol.

And yes, sugar is way up, but it is nowhere near its all-time high. Illovo Sugar, the largest African sugar producer, could be a cheap, smart sugar play. It trades on the Johannesburg exchange, and like Anonymous said, you can get your hands on shares via the Pink Sheets.

“I understand how ethanol can work if you can make it from sugarcane, or switch grass, or manure, or other waste, but how can it work in commercial agriculture growing crops that are traditional in the U.S.? The farmer has fossil fuel delivered to his farm at a cost, he prepares the field with fossil fuel, he plants using fossil fuel, cultivates with the same, fertilizes with, harvests with, and delivers with, then the crop is processed into ethanol with fossil fuel, and then it must be delivered into a marketplace with fossil fuel. After all that, there is still a positive gain in BTUs? I would sure like to hear the definitive truth on this issue.” — Ken

Well, Ken, Ethanol Across America, a non-profit education campaign of the Clean Fuels Foundation, has published just such a study to examine the energy balance of ethanol.

Here’s EAA’s take: Ethanol is unfairly criticized, like when all the energy attributed to grow a bushel of corn and process it is counted. The report calls ethanol a co-product of corn, and that means that the corn should only be charged with the energy that was used to turn it into ethanol. After all, corn is a commodity, and it’s probably not grown for a specific purpose — so it is grown due to overall demand and sold into broad markets.

And here’s another argument EAA takes on to battle the “balance of energy” argument: Assume a pile of coal has a latent heat value of 1 million BTUs, but it can be converted into a liquid fuel that can produce 500,000 BTUs. The liquid fuel becomes more valuable because you can fill your tank with it to make your car go. Unfortunately, the same cannot be said for coal.

The report goes on to say that if you limit the debate strictly to BTU’s — then the argument that ethanol production is inefficient is bunk. For instance, electric power plants using coal are only 35% efficient. Basically, any type of energy conversion results in a negative energy balance.

The age of cheap oil is over, and whatever “hidden costs” are mentioned to try and debunk whatever the new alternative fuel is, people will still need to get around, food will still need to be delivered to grocery stores, and planes will still need to circle the globe. Our best stab at the definitive truth is this: The age of cheap oil is over, and something(s) will need to come along and supplement and/or replace it.

“You might want to look at STKL. I primarily invested in this company because of its organic food. They are starting to get noticed because of their cellulosic ethanol technology… With the technology they have they don’t need corn to create ethanol, which solves one of the problems you brought up.” — Ron

Nice find, Ron. SunOpta Inc. (STKL: NASDAQ) basically deals in biomass conversion. They have a steam explosion machine that can process all kinds if wastes and vegetable matter including wood chips, sugarcane, cereal straws, and waste paper.

“In their natural state, these materials are not easily separated into their component parts. By processing with the addition of high-pressure steam, the StakeTech Steam Explosion System breaks the chemical and physical bonds that exist between the components of these materials, allowing their subsequent separation and processing into products and components that potentially have wide and diverse applications,” according to the company’s website.

The company is focusing its efforts on the pre-treatment of biomass for the production of ethanol, which has made it a hot commodity on Wall Street. In the beginning of January, the $472 million company traded for around $5.25. Now the price is up to around $8.30 thanks to some heavy volume.

“I have spent the last year intensely studying both ethanol and biodiesel. The reality is that both fuels will be needed to wean this country off our petroleum dependence.  But I think the case for biodiesel as a better fuel can be made.  Europe, India, and now China are putting major efforts to switching to biodiesel.  Here’s why. Biodiesel can be made out of any fat or vegetable food or non-food oil. The list is endless, and includes recycled and waste oils from various processes. Where ethanol grows only in the middle of the country, a company called Fry-O-Diesel is researching how to use the unlimited supply of trap grease and waste cooking oil.  California has 88,000 restaurants in its trade organization and that represents about 75 million gallons of waste oils. Biodiesel plants so far have primarily been soybean oil based so far but that will change over the next 5 years as these new technologies get perfected that can use whatever fats and oils are available.” — Kari, Biodiesel Council of California

In the long run, I think both ethanol and biodiesel will find their respective places in the market. But for the time being, ethanol has a greater chance of growing because the country is more prepared for it. A regular gas-burning car can run on the lower-concentration ethanol blends. So it’s a good start without having to go out and buy new hardware, so to speak. And flex-fuel vehicles that can run on higher concentrations of ethanol in gasoline are also carving out their niche.

Kari continues: “To truly deal with the reality of global warming we must lower our use of petroleum in all vehicles, heavy and light, and get the absolute best fuel mileage possible. Diesel-Hybrid technology has been used on trains for decades, it is just now being crossed over to vehicles in both the heavy and light classes.”


By Greg Guenthner
For The Daily Reckoning

The Daily Reckoning