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Ethanol stocks to get revved up about
Finally, support for ethanol fuel is firing on all cylinders and the industry is undergoing massive growth as it goes mainstream. Here are the stocks investors should watch.
By Michael Brush
A century ago, Henry Ford planned to make ethanol -- a form of alcohol derived from sugar or grains such as corn -- the primary fuel for his Model T.
The Model T that was first produced in 1908 would, in fact, run on either ethanol or gas. But gas was cheaper and became the dominant fuel, then and now. Ford's vision of widespread ethanol use, though, is getting closer to reality.
Starting in May, Americans will be putting a lot more ethanol in their tanks as refiners drop the additive methyl tertiary butyl ether (MTBE), which is used to make gasoline burn cleaner. The additive may cause cancer, and Congress has declined to offer refiners protection from legal liabilities that may arise from MTBE use. MTBE -- which makes up about 1.5% of the countrys gasoline supply, or around 2 billion gallons -- will be replaced with ethanol.
Long term, there are even bigger forces at work that should spur greater ethanol use. Americans are getting fed up with dependence on oil from the Middle East and high gasoline prices, and they are telling their politicians to do something about it.
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And the politicians are responding: - Last summers Energy Policy Act of 2005 requires gasoline producers to nearly double the use of renewable fuels -- chiefly ethanol -- by 2012. Mandated use will rise to 7.5 billion gallons by 2012, from 4 billion gallons in 2006. Thats still a small portion of overall gasoline use, as Americans burned about 140 billion gallons of gasoline last year.
Many experts believe Washington will increase the requirement each year -- because ethanol has such strong bipartisan support. The bill also offers tax incentives for service stations to sell E85, a blend that can contain as much as 85% ethanol, for use in so-called "flex cars" that run on ethanol.
- In his January State of the Union address, President George Bush offered a ringing endorsement of ethanol and pledged money to fund research on new production methods.
- Ethanol has solid bipartisan support at the local level, too. Forty-five states have enacted policies to stimulate ethanol production and consumption.
"For the first time in a long time everybody is rowing in the same direction," says Mark Emalfarb, chief executive of Dyadic International (DIL, news, msgs), a company that makes enzymes used in ethanol production.
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Predicting 'massive growth'
Sheer economics are playing a role, as well. As crude oil and gasoline prices remain high, producers look to stretch each gallon of gasoline by adding ethanol, says Aaron Brady, the assistant director of oil research at Cambridge Energy Research Associates.
"Gasoline consumption is increasing 2% a year, and we havent built a new refinery since the 1970s. So alternative fuels have to be part of what fills that gap," agrees Tim Newkirk, the chief operating officer of MGP Ingredients (MGPI, news, msgs), an ethanol producer. "Otherwise we are going to be even more dependant on foreign oil and also foreign gasoline."
Meanwhile, auto companies like Ford (F, news, msgs) and General Motors (GM, news, msgs) are ramping up promotion of flex vehicles that run on E85 -- hoping they will catch on like hybrids that combine the use of electrical power and gasoline. "Already we are seeing a significant increase in interest," says Bob Dinneen, president of the Renewable Fuels Association.
Taken together, these factors have pushed the price of ethanol well north of $2 a gallon, which means producers are enjoying healthy profits -- since they can make the stuff for $1 to $1.20 a gallon. "The industry is undergoing massive growth as producers expand and as new participants enter the market," says Friedman, Billings, Ramsey analyst Jacques Rousseau. He believes demand will push use of ethanol well beyond the federally mandated minimums -- to 10 billion gallons a year by 2010.
Ethanol's big guns
Producers in the U.S. typically make ethanol by milling corn into flour and then converting the starch to glucose by adding enzymes and cooking it. Then it is fermented into a kind of beer, and the alcohol is distilled off. The country has 97 plants and 33 are under construction, says Dinneen.
Archer Daniels Midland (ADM, news, msgs) is the most obvious ethanol play -- since it controls about 25% of the capacity in the U.S. The company gets about 25% of its operating profits from ethanol and the sale of related byproducts. "Ethanol and bio-fuels are certainly going to be a key driver," says Morningstar analyst Greggory Warren. "They are pumping a lot of money into it. They are talking about spending billions on ethanol and bio-fuel production in Europe, too."
Warren, however, thinks the stock is too expensive, and he is not alone. "With the tightness in the gasoline market it has had a nice run," agrees Brian Hicks, co-portfolio manager of U.S. Global Investors Global Resources Fund (PSPFX). "We are waiting for a pullback before we make a move."
Pacific Ethanol (PEIX, news, msgs) is the biggest pure play on ethanol production. The company currently markets ethanol in several western states including California, Nevada, Arizona and Oregon. But it hopes to have five ethanol plants running in the region by the end of 2008. Its first plant, under construction in Madera County, Calif., should be on line by the end of this year.
"Pacific Ethanol is positioned to achieve substantial growth starting in late 2006," says Dutton Associates analyst Paul Resnik. "We believe that the company can turn profitable in 2007 and generate significant earnings in 2008 and beyond." Resnik thinks Pacific Ethanol will make $1.21 cents a share in 2008.
Bill Gates, the co-founder and chairman of Microsoft (MSFT, news, msgs), has made an $84 million investment in Pacific Ethanol through an investment company called Cascade Investment. (Microsoft is the publisher of MSN Money.)
The niche players
Two other companies in ethanol production are MGP Ingredients, which gets about a third of its revenue from ethanol produced at two plants in Kansas and Illinois, and Green Plains Renewable Energy (GPRE, news, msgs), a recent initial public offering with plans to build an ethanol plant in Iowa.
Another play on ethanol is to buy companies like Dyadic International and Diversa (DVSA, news, msgs), which are developing enzymes for use in what may be the next generation of ethanol production techniques talked up by Bush in his State of the Union address.
Currently, producers sell the corn mash byproduct from ethanol for use as animal feed. But the byproduct, known as dry distillers grain (DDG), may also be reprocessed to extract more ethanol. "The ethanol companies are selling DDG for animal feed, but about half of it could be used to create (more) ethanol," says Dyadics Emalfarb.
Ethanol can also be made from other kinds of cellulose like corn stalks, straw or wood chips. These techniques arent commercially viable right now -- but researchers at big ethanol producers are working to find ways to bring costs down.
Sugar cane is also an ethanol play because its the base ingredient used to make the fuel in Brazil, the worlds second-largest ethanol producer. Brazil's use of sugarcane to make ethanol has helped drive up sugar prices around the globe. For more on how energy demand is turning sugar into a sweet investment plan, check out Jon Markman's take on the topic.
At the time of publication, Michael Brush did not own or control shares of companies mentioned in this article.
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