Ethanol: An Uphill Climb

We already know that America is by far the largest consumer of oil in the world. We have actually known that for a long time, it just wasn't until recently that The Powers That Be decided that this is a dangerous thing. So, it appears that the next big investment opportunity is to reduce that number drastically, and we are diligently putting our best scientists to work at it. But can we quantify the challenge ahead of us? Is it possible to displace our appetite of 20 million barrels of oil consumed each day? Or 400 million gallons of gasoline each day? This translates to an unnerving 146 billion gallons of gasoline consumed in America each year that we are seeking to displace.

Ethanol is a leading candidate for this task and the E85 blend of ethanol fuel can be mass-produced at this point, but to displace a full 85% of petroleum would require annual production of 124 billion gallons. As mentioned earlier, current annual ethanol capacity is less than six billion. So, from a production standpoint, we've got a long way to go. While this can be looked at as a great market opportunity, the challenges nonetheless don't stop there. Corn ethanol, the dominant technology on the market today, uses corn kernels as the feedstock in the manufacturing process. By design, this process uses fossil fuels to generate ethanol, but is largely inefficient as, according to the U.S. Department of Energy, the energy input/output ratio is only about 1:1.4. Additionally, there simply is not a large enough corn supply to support this kind of production. In fact, NREL estimates that our existing corn supply could only provide for approximately 13% of our ethanol needs.

Furthermore, not only do vehicles have to be specially manufactured as "flex fuel vehicles" to accommodate this kind of fuel, the E85 blend cannot be used in any traditional gasoline pump because it corrodes the traditional material used to store and pump gas. To that end, there are only about 1,000 stations that dispense E85 fuel. (And yes, this represents a huge business opportunity for someone else too…but the point is that there is a ways to go . . . sound familiar?)

Oh yeah, what about the one factor that most Americans will pay the most attention to – the cost? Currently, a gallon of ethanol is comparable to a gallon of gas at the pump, but it is important to remember that ethanol contains less energy than traditional gasoline, thereby producing lower fuel efficiencies. Moreover, there is price volatility in the ethanol market just like the crude oil market. A frenzy of players has entered the ethanol space and is heightening the demand for its primary input: corn. The market spot price of corn was over $3.50/bushel at the end of 2006, compared with less than $2/bushel a year prior. This will squeeze ethanol producer's margins and will inevitably raise the price of the finished product. Ethanol producers thus face the paradox of increasing demand for their product – at their own expense. At the same time, a rising price at the pump may cause consumers to revert back to traditional gasoline. US corn growers are certainly enjoying their new windfall, but the end user and the investor don't seem to be reaping the same benefits.

At the rate we're going, what we could very well see at the end of the day is just an overcapacity of ethanol and a bunch of frustrated investors. Is there any way to counteract that? There may be, and it comes in the form of "cellulosic" ethanol. But this technology is not without its challenges too. And what will it mean for investors? Stay tuned, and we'll explore this type of fuel shortly.

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