Ethanol: Should You Invest?

Investors have been scrambling lately to find the next "new" thing to ride the wave to riches in the energy sector. In this scramble, ethanol has been touted as one alternative fuel that could help rid the U.S. once and for all of its dependence on foreign oil.

This feverish speculation has helped drive stock prices for companies such as  Archer Daniels Midland  (ADM),  Deere (DE), and  AGCO (AG) through the roof as of late. Even seed producer  Monsanto  felt the need to remind investors that it has exposure to the ethanol market on a recent call. Given all the attention ethanol is getting in the headlines and in the stock market, we figured that now would be as good a time as any to throw our two cents in on the topic. In short, our position is that while the shift from using methyl tertiary-butyl ether (MTBE) to ethanol as a gas additive will certainly improve near-term ethanol production, there is still much to be done if ethanol is to prove itself a long-term solution.

There is no arguing that ethanol consumption in the U.S. will increase. The first driver is petroleum companies' decision to remove MTBE from their gasoline in response to state bans and liability exposure from water-contamination issues. The Energy Information Administration estimates that this will immediately increase our ethanol demand to over 400,000 barrels per day (or 6.1 billion gallons per year). In contrast, the U.S. ethanol industry produced 255,000 barrels per day (or 3.9 billion gallons per year) in 2005.

The second driver is the Renewable Fuels Standard (RFS) of the Energy Policy Act of 2005, which requires the production and use of 4 billion gallons of renewable fuels in 2006, increasing to 7.5 billion gallons in 2012. Both ethanol and biodiesel are considered to be renewable fuels, although biodiesel production is minuscule compared to ethanol production. Assuming that the RFS sets the floor for ethanol consumption, we can project that consumption will grow by about 3% to 4%, compounded annually, between 2006 and 2012. And that's on the back of the 60% increase in consumption that we should see in 2006 due to the MTBE phaseout.

On a long-term basis, though, the debate regarding the viability of ethanol as a substitute remains unresolved. David Pimentel, a professor at Cornell University's College of Agriculture and Life Sciences, has argued that more energy is used to produce a gallon of ethanol than the energy contained in a gallon of ethanol. Proponents of ethanol would be well advised to consider the entire production cycle and cost of ethanol when considering its economic merits. There is no ignoring the amount of energy implicitly used in planting, irrigating, fertilizing, harvesting, transporting, baking, and distilling any crop to make ethanol. The problem is both cumulative and circular. Cumulative because of all the energy consuming steps and circular because as you increase ethanol production, you increase the use of fossil fuels--especially natural gas--theoretically causing fossil fuel and, thus, ethanol costs to rise.

Of course, there have also been many scientific studies arguing that ethanol has a positive net energy balance. Hosein Shapouri, an economist at the U.S. Department of Agriculture, has supported this side of the argument, and scientists have been busy working on improving the efficiency of the process. Additionally, there is merit to the less-tangible value that would be created by weaning America off its foreign energy dependence that could help close the cost gap.

We do not yet know who is right on this issue. But it seems to us that the net-energy-balance question will need to be resolved before the U.S. can even consider ethanol as a long-term substitute for petroleum.

Once the energy question is resolved, proponents of ethanol can shift their attention to tackling the need for the massive infrastructure spending that will be required to support the shift from gasoline to ethanol. As a starting point to that discussion, we need to look no further than the difficulties the industry is encountering in trying to meet the current MTBE phaseout and the RFS. Ethanol can't be transported or stored along with regular gasoline until the last step in the distribution chain. Plus, ethanol-blended gasoline can't be intermingled with other gasolines during the summer. These extra steps mean extra costs, and consumers can expect to see pump prices rise because of the switch--hardly what one would expect from a substitute that is supposed to lower costs.

Beyond the obvious short-term infrastructure issues, to meet our long-term needs, we would need to build a new refining, pipeline, and storage system to get the ethanol from the Midwest to the rest of the country. We basically need to recreate what the oil industry has spent the past 100 years building and perfecting. This is no small challenge and shouldn't be taken lightly. In this challenge, there will undoubtedly be numerous investment opportunities and likely an even greater number of pitfalls that investors could fall into.

Still, despite all the challenges surrounding a long-term switch to ethanol, we would be remiss if we failed to acknowledge that there is a very powerful ethanol lobby behind this push. At the end of the day, expanding ethanol's use may be more a matter of political will and special interest influence than anything driven by fundamental economics.

So while we remain open to the possibility that ethanol is playing and will play a larger role in the world's increased thirst for fuel, we still think that betting on broad use at this time is pure speculation. One way to cure our skepticism would be for a company like Deere to introduce farm equipment that ran on the 85/15 mix of ethanol and gasoline. We can't think of a better way to jump-start ethanol use than to begin converting the equipment fleet closest to the source. Until that time, we'll leave the speculation to others.