Biofuels Bonanza

There are two primary drivers of global crop demand: increased demand for biofuels and dietary shifts in developing countries. Both demand drivers favor higher prices next year.

Biofuels are liquid fuels derived from agricultural products. The most important biofuel in the US market is ethanol, an alcohol made primarily from corn. This year the ethanol industry is projected to consume 4.2 billion bushels of corn, roughly one-third of total US corn production.

The benefits of ethanol as a fuel are dubious and subject to considerable debate, but that’s not what’s most important to investors right now. Plenty of powerful legislators in the US Congress from both sides of the aisle hail from farm states, and agricultural lobbies generally support greater use of ethanol–a key source of crop demand.

More important, the US is already mandating greater ethanol consumption. The first push for ethanol demand in the US occurred when regulators phased out a key fuel additive, methyl tert-butyl ether (MTBE). MTBE had been added to fuel for many years as an oxygenate to reduce carbon monoxide emissions from cars and trucks. MTBE is also an octane booster that helps to reduce engine knocking and other performance issues.

But MTBE can leach into groundwater supplies and is thought to be a carcinogen; the US government effectively banned MTBE as a fuel additive.

One of the only economical substitutes is ethanol. Because ethanol is among the only MTBE alternatives available in large quantities, it’s effectively replaced MTBE. But ethanol demand is now powered by far more than simple MTBE replacement.

The US also has enacted several mandates designed to foster ethanol use, the most recent being The Energy Independence and Security Act of 2007, signed into law on Dec. 19, 2007. This act replaced and extended renewable fuel mandates already in place from a similar law enacted in 2005.

The 2005 act required that the US use 7.5 billion gallons of ethanol by 2012; for reference, in 2007 the US consumed 6 billion gallons of the fuel. The 2007 bill more than doubled the total mandate to 15.2 billion gallons. In addition, the most recent renewable fuel standard extends the mandates for another 10 years, requiring that the nation boost biofuels consumption to 36 billion gallons by 2022.

This mandate includes several other key provisions. Out of the 36 billion gallons of biofuel that the country is expected to use in 2022, 21 billion gallons must come from advanced biofuels. The term advanced biofuels refers to ethanol (or biodiesel) derived from sources other than cornstarch. The leading form of advanced biofuel in the US is cellulosic ethanol, which is derived from products such as corn stalk waste or switchgrass, a prolific prairie grass.

But there’s a problem with this most recent mandate: It’s not possible for refiners to blend 15 billion gallons of ethanol with gasoline by 2012. The problem isn’t a lack of ethanol production capacity; there’s likely an oversupply of ethanol production facilities in the US. Verasun Energy and other prominent ethanol producers have declared bankruptcy and shuttered plants in recent years because of weak profit margins.

The problem is flat-to-falling US gasoline demand. According to BP (NYSE: BP), the US consumed roughly 9 million barrels of motor gasoline per day in 2009. That works out to roughly 3.29 billion barrels (138 billion gallons) of gasoline annually. The current maximum allowable ethanol blend is 10 percent, which equates to 14 billion gallons of ethanol based on 2009 gasoline consumption.

Of course, US gasoline consumption should recover somewhat alongside the economy. But consumption would need to jump almost 9 percent by 2012 for the country to approach the required 15 billion gallons in blended ethanol at the current 10 percent blend rate. As I’ve written frequently in The Energy Strategist, US gasoline demand growth is likely to remain subdued or even negative because of higher prices.

The real story is going on overseas. Emerging market demand is key to understanding the global oil markets. But if my flat US demand and strong global demand thesis is even partly correct, the targeted 15 billion gallons of ethanol consumption appears to be unattainable.

One solution that’s under consideration is to increase the allowable ethanol blend rate from 10 to 15 percent, a decision that would allow refiners to meet their mandate even if US gasoline demand falls from current levels. Not surprisingly, the ethanol industry has petitioned the EPA to do just that, and the agency is considering the request.

I suspect the EPA will comply with the ethanol industry’s request for three major reasons. First, as I noted earlier, there is considerable support in Congress for the farming lobby. Second, the main argument against increasing the mandate is that it could cause damage to engines; however, most studies suggest modern US cars can handle blend rates of 15 percent without significant problems.

And third, an increase in the blend rate would promote cellulosic ethanol. At the Energy Information Administration (EIA) conference back in April, I attended a seminar discussing the potential for cellulosic ethanol. All participants I spoke to agreed that cellulosic ethanol research was a major priority for both the Obama Administration and the Dept of Energy (DOE).

The technology already exists to produce ethanol from waste products, but the process is expensive and the industry is still in its infancy.

There are plenty of companies out there that claim to be able to produce cellulosic ethanol at gasoline-competitive prices, but there’s a huge difference between success in the lab and commercial-scale production. I suspect that the industry is not as far along the path to commercial production as its proponents would suggest. Call me a skeptic but I’ve seen too many promises about cellulosic ethanol come to naught over the past five years.

And if corn-based ethanol producers are struggling to make money, cellulosic ethanol producers are unlikely to fare much better. Further, if there’s already overcapacity of corn-based ethanol production in the US, there’s little incentive for a cellulosic producer to add to the glut of ethanol. And given falling gasoline demand, it’ll prove particularly tough for refiners to meet Congress’ mandates for advanced biofuels use.

But if the EPA were to raise the blending limit, it would instantly create a bigger market for both cellulosic and corn-based ethanol. For better or worse, the EPA likely will increase the blending limit to advance the Obama Administration’s goal of promoting cellulosic ethanol. I expect that decision to occur before the middle of 2010. An increase in the ethanol blending rate would accelerate demand growth for corn.

How to Play It

Sometimes knowing which stocks to avoid is just as valuable as picking winners. Although ethanol producers were once the darlings of momentum traders, I’ve consistently warned investors to steer clear of these stocks. This caution has paid off for investors who followed my advice; several ethanol producers have filed for bankruptcy, while others–such as the formerly hyped Pacific Ethanol (NSDQ: PEIX)–are now penny stocks.

I continue to recommend that investors eschew pure-play biofuels producers and gain exposure to these growth trends via several biofuel plays of varying risk levels. Most of my preferred plays are either producers of agricultural products or companies that sell crucial products or inputs to the agricultural industry.

Seeds

Genetically modified (GM) seeds have encountered strong opposition from environmentalists and consumer advocacy groups, particularly in the European Union. Such crops are still derided as “Frankenfoods,” but ultimately the consumption of non-GM and organic food is an expensive luxury for consumers in developed countries.

It will be tough to turn the tide: GM crops offer higher yields than conventional seeds, and the latest stacked seeds can grow during droughts and other unfavorable conditions. Regardless of your feelings about GM crops, this agricultural technology is a necessity if the world is to have any hope of feeding the world’s growing population.

Monsanto (NYSE: MON) is the world leader in GM seeds and is at least 18 to 24 months ahead of its competitors in terms of seed technology. GM crops are nothing more than plants designed to exhibit certain beneficial characteristics known as traits. Nowadays traits are stacked so that a single crop offers multiple genetic advantages.

Monsanto recently hosted its biennial two-day analyst meeting, updating investors on progress in the development of cutting-edge crop technologies as well as the company’s growth outlook.

Analysts had expressed concerns that weakness in the company’s Roundup herbicide business would imperil its long-term goal to double its gross profit by 2012. Profitability in the Roundup business deteriorated last year because competition from generic competitors in China, falling prices and general demand weakness. But management makes a compelling case that growth in its seeds business will more than offset these issues.

In the near term the spotlight is on two products: SmartStax Corn and Roundup Ready 2 Yield soybeans.

The former is a GM corn that resists root, stalk and ear insects. In addition, the corn has traits that make it resistant to herbicides like roundup, allowing farmers to kill weeds without damaging the corn. The technology should enable farmers to boost their crop yields 5 to 10 percent. Management expects to SmartStax to be planted on more than 4 million acres of land in 2010 and sees that figure quadrupling to 16 to 18 million acres in 2011. This is a faster ramp-up for the product than many observers had expected.

Roundup Ready 2 Yield soybeans also contain multiple traits, including herbicide resistance. Monsanto claims that these seeds will increase yields 7 to 10 percent.

Monsanto is working on a drought-resistance corn varietal that could grow in what’s now considered marginal farmland. This is particularly attractive proposition, as water shortages remain a big problem for farmers in many regions of the world. Buy Monsanto.

Syngenta (NYSE: SYT) has traditionally focused on herbicides and pesticides rather than GM seed development. But in recent years the company has expanded the latter business as well.

The herbicides and pesticides business also took a hit last year when farmers cut back on spending in every possible area. But with farmers’ income expected to improve into 2010, spending crop protection will also recover.

And Syngenta produces a number of specialized products with limited competition; the company appears to be gaining market share and is well-positioned to take advantage of the coming upturn. Asian rust has wreaked havoc on corn crops across the Americas, and

Syngenta produces a niche chemical that helps control this devastating disease.

Syngenta’s seed business just isn’t in the same league as Monsanto’s, but with a shortage of GM seeds across key markets there’s room for multiple competitors. And Monsanto’s SmartStax corn is more expensive than the older, less-sophisticated corn varietals Syngents produces–some farmers may opt for the older technology rather than paying up for the latest stacked traits. Buy Syngenta.

The Other Biofuel

Palm oil is produced from the fruit of a particular type of palm tree. As with most palms, this tree requires a tropical climate and is normally found near or around the equator.

Malaysia and Indonesia dominate production of palm oil, each producing around 16 million metric tons per year. The next-highest producer is Thailand, which produces around 1 million metric tons.

Palm Oil isn’t as well-known to US consumers as canola oil (rapeseed oil), olive oil or oil derived from soybeans. However, it’s commonly used in candy bars and other processed food products. China is the world’s top consumer of palm oil; in fact, palm oil has traditionally been the most popular edible oil in the country.

I see strong growth in palm oil consumption for two reasons. First, the same principle of diet upgrading that applies to meat (a trend I discussed in detail in my article Green Acres) also applies to fats, oils and sweets; as countries become wealthier and consumers’ disposable income rises, spending on fats, oils and sweets increases quickly. The graph below tracks palm oil consumption in China over the past 40 years.

Source: USDA

The data speaks for itself: Chinese palm oil consumption has increased six-fold over the past decade alone and is projected to reach record highs this year.

Of course, food upgrading doesn’t explain the following chart.


Source: USDA

This chart depicts palm oil consumption in North America and the European Union (EU). Consumption of palm oil has increased steadily in North America, but the rise in the EU is far more dramatic thanks to biodiesel. Diesel-powered passenger cars are far more prevalent in the EU than in North America, and biodiesel–a diesel fuel made from oils–is the biofuel of choice. The region has mandates for increased biodiesel use to encourage consumption.

Canola oil is produced in the EU, but palm oil can be a cheaper biodiesel feedstock depending on price movements. Demand for palm oil is also rising as a biodiesel feedstock.

My bet on this trend includes three plays: M.P. Evans Group (UK: MPE; OTC: MPEVF), Anglo-Eastern Plantations (UK: AEP; OTC: AEPLF) and SIPEF (Belgium: SIP; OTC: SISAF). The first two plays are relatively small companies that own palm oil plantations in Malaysia and Indonesia. Sipef is a bit larger and more diversified, owning palm oil, tea, banana and other plantations. All three rate buys.

But investors should steer clear of Landkom International (UK: LKI), a UK-based company that owns farmland in the Ukraine where wheat and rapeseed are produced, the latter mainly for biodiesel production. Financing issues and weak pricing for its key commodities have weighed on Landkom’s stock over the past year. The firm is issuing new shares in an effort to raise capital.

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