Comically Terrible Timing
In June 2006 I read an article at Financial Sense that promoted ethanol as a great place to put your money:
Investing in Ethanol: A “New” Stock Play on Soaring Energy Prices and Why Now is the Time to Invest in this “Fuel of the Future”
Among the gems in the article were these:
Strap on your seatbelt… an alternative energy source is set to take the world by storm. In this research report, we’ll take a close look at the booming ethanol industry… and how investing in ethanol could prove to be an extremely profitable move for investors.
With a mandate from the U.S. government and the obvious need for change, we see this as a fantastic opportunity for investors to earn serious profits.
Take a look at recent investments made by some of the richest and most successful people in the world:
* Bill Gates, the richest man in America, allocated $84 million into Pacific Ethanol, Inc. (Nasdaq: PEIX), a company poised to control a considerable share of the ethanol industry.
Not So Fast
Mary Puplava at Financial Sense had asked me if I would contribute an article there, and I had procrastinated up to that point. But the article above prompted me to write a rebuttal. I told Mary that investors “are going to get trounced” if they take the advice from that article, and I wrote to her in an e-mail that “fundamentally something like Pacific Ethanol is a very poor investment (despite what Bill Gates thinks).” My rebuttal:
In the three months following that rebuttal article, ethanol stocks fell across the board by about 40%, including Pacific Ethanol which I highlighted in the article. (An analyst at one brokerage firm told me that they advised clients to sell ethanol stocks after reading my article). I followed up a few months later with:
I am getting around to the point here, which isn’t actually to argue that I am a financial genius. (As a matter of fact, my portfolio since last summer looks like almost everyone else’s: Down sharply). No, what I want to focus on here is just how that article – and investors like Bill Gates – could have missed so horribly with ethanol stocks. The reason this is pertinent is that I get an e-mail every week or so from someone wanting to know which cellulosic ethanol play I would recommend. For similar reasons to why I disputed that 2006 article on investing in ethanol, the answer is “none of them.”
Why the Advice Was Wrong
The initial article was correct on one key point: On the back of mandates and heavy subsidies, the ethanol industry was poised to grow dramatically. But there were two really big problems for prospective investors wishing to capitalize, and a third if you happened to be an investor in Pacific Ethanol. First, the fact that ethanol has to be mandated to gain market share should have been a strong tip-off that the economics didn’t look all that good. The companies simply were not poised to compete in the marketplace, hence the mandates.
Then there was problem number two: Producing ethanol isn’t rocket science. The barriers for entry into the marketplace are low, meaning competitors were going to sprout up everywhere. I documented a number of cases where complete amateurs decided they were going to get into the ethanol business. I can assure you that complete amateurs don’t go around building oil refineries, because the capital costs and technical challenges pose a very high barrier that Bob the Dentist and his buddies aren’t going to overcome by pooling their money and channeling their passions.
So as a result, ethanol capacity was overbuilt, there was too much competition, and margins vanished. This has led to a wave of ethanol bankruptcies and plant closings. In hindsight, it is clear that ethanol was not the place to sock away your money.
Pacific Ethanol faced an additional challenge: They built their plants far from the raw materials needed to run the plants. I could foresee that an ethanol plant in Iowa could put ethanol in Pacific Ethanol’s backyard for cheaper than they could do it themselves after the logistics of corn imports and DDGS exports were taken into account. The fall for Pacific Ethanol has been steep. Once boasting a market capitalization of over $1 billion (in 2006), that has now fallen to $23 million. Bill Gates eventually decided that Pacific Ethanol wasn’t what he thought it was, and sold out his shares.
The Game is Now Cellulosic Ethanol
So now here we sit in 2009, and many now want to know how to make money with cellulosic ethanol – the next big thing. As I told someone last week, “this is a low margin business.” Why do you think the government not only has to mandate ethanol, but then put extra mandates and goodies in for ethanol made from cellulose? Because the economics look horrible. No producer is going to be able to gain a decided advantage over others. There will be producers of cellulosic ethanol. That technology exists. It just doesn’t exist economically, and nobody is going to do it and make consistently high margins.
Take Verenium, for instance. There was a recent story in the news that they have teamed up with BP on a cellulosic ethanol venture:
Within that story was a little detail that I found interesting:
The joint venture expects to break ground on the Florida site in 2010, the press release said, and the estimated construction cost for this 36 million gallon-per-year facility is between $250 million and $300 million.
Ah, capacity and capital costs. That’s the sort of information we can put to good use. What do we find? Capital costs for this 2300 barrel a day facility amount to almost $130,000 per daily barrel. (To put that scale into perspective, a 60,000 barrel a day oil refinery is considered to be small). The following is starting to become a little dated, but I still like it for its relative comparisons:
Source: EIA Annual Energy Outlook 2006
When someone argues that coal-to-liquids companies might make for good investments, for instance, I point out that capital costs are about double those for gas-to-liquids (GTL), and those GTL projects are being canceled because their costs are too high. So think now about the capital costs of this Verenium venture, and consider the fact that corn ethanol plants with a fraction of the capital costs are going bankrupt. This is not to say that Verenium won’t successfully produce cellulosic ethanol. I just predict that the economics will not allow them to compete with other energy options, and they will live or die by the mandates. Likewise, I believe the same is true for most companies that have aspirations of making ethanol from cellulose.
Are There Any Investment Opportunities Here?
OK, I did say ‘most companies.’ I am hedging a bit, because some company might come up with something slightly advantageous. Will this make cellulosic ethanol a high-margin business for them? No, and if you want to play this game, you are trying to pick a winner out of a pack of losers. Safer in my opinion to stick with a sector that looks like an overall winner.
Look for a company that enables cellulosic ethanol. Buy the company that makes the novel enzyme for cellulose hydrolysis or the membrane system for the separation, not the company that uses them to make ethanol. Profit margins on the former might be good. Profit margins on cellulosic ethanol will at best mimic those of other commodity energy sources.