Profiting in Biofuels

The ethanol boom may defy economic logic and could easily drive up food prices. It certainly depends on the generosity of taxpayers, but it makes eminent political sense in Washington, D.C. With a rallying cry of "Money to the Midwest, not the Middle East," politicians say they are addressing our addiction to foreign oil by promoting the use of two crops in abundant supply in the U.S.: corn, which is used to make ethanol, and soybeans, which are used to make biodiesel fuel.

You can invest profitably in biofuel stocks, thanks to those helping hands from Uncle Sam and many state governments. Some of the stocks retreated recently as the price of oil dropped, enhancing their appeal. But before we tell you how to invest, here's a quick primer on this dynamic business.

Energetic gains

The production of U.S. ethanol, nearly all distilled from the starch and sugar in corn, is growing explosively -- four billion gallons last year, five billion this year, six billion next year, according to Matt Hartwig, of the Renewable Fuels Association. Forty percent of the nation's gasoline already contains ethanol, says Hartwig, who thinks the domestic ethanol business can expand to 15 billion gallons by 2015 (current total annual gasoline consumption is 150 billion gallons).

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The federal government last year mandated that the oil industry use at least 7.5 billion gallons of biofuels by 2012, a mandate that many analysts think may be raised. Government lavishes a tax credit of 51 cents a gallon on ethanol (and an even more lush $1-per-gallon credit on biodiesel, refined from oil-bearing crops) and shelters the industry with a 54-cent-per-gallon import duty aimed principally at low-cost Brazilian ethanol, which is distilled from sugar cane.

Clean burn

But the main impetus behind the surging demand for ethanol this year has been its role as a replacement for MTBE, a clean-burning, high-octane gasoline additive now believed to be a carcinogen. State after state has banned the additive. Ethanol is the only feasible substitute, and many states are mandating at least 10% ethanol content ("E10" at the pump) in gasoline.

What are the risks of investing in ethanol? A change in government policy is one, but that seems less likely than shifting business economics. Falling oil prices and rising corn prices would squeeze ethanol refiners' profit margins. Demand for ethanol now exceeds supply, but dozens of plants are under construction, and supply could catch up by the end of 2008. For now, the established companies are solidly profitable. Moreover, stock prices of the key players described here are well below recent highs, and price-earnings ratios range from moderate to low.

Ethanol giant

Any discussion of ethanol stocks should start with industry giant Archer Daniels Midland (ADM). ADM pioneered the U.S. industry in the 1970s, lobbied aggressively (and successfully) for tax breaks, and has dominated ever since.

ADM declined to talk to us, but it's clear that the ethanol boom is behind a 160% surge in profits (to $1.3 billion) over the past two years. The big commodities processor is also a major factor in Europe's biodiesel industry, the most developed in the world, and its expertise is carrying over to its operations in the U.S. and Brazil.

If it's a pure ethanol producer you seek, consider Aventine Renewable Energy (symbol AVR). Since going public in June at $43, Aventine's shares have slumped to $24, making them far more attractive.

Tim Flannery, a hedge-fund manager at Front Point Partners, in Chicago, likes Pekin, Ill.-headquartered Aventine for its strong executive team, marketing skills and distribution capabilities. Anyone can throw up an ethanol plant in midwestern cornfields, but not many suppliers have the infrastructure to move the stuff around and satisfy customers such as ExxonMobil and Chevron. Aventine is both a major producer of ethanol and a distributor for other distillers. Front Point expects Aventine to earn $1.91 a share in 2006, swelling to $4.26 by 2008.

If ADM is the king of corn processing, then Bunge (BG) rules over oil seeds. So it's no surprise that Bunge, based in White Plains, N.Y., entered into biofuels through Europe's fast-growing biodiesel industry. In Europe, rapeseed (canola to North Americans) is the crop of choice for biodiesel. Now cosmopolitan Bunge is building biodiesel plants in Illinois to process soybean oil and has announced ethanol projects in Iowa and Mississippi situated near Bunge corn elevators. Bunge is also the largest supplier of fertilizer and crop nutrients to Brazil, an agricultural powerhouse.

Brazil is a global leader in the ethanol industry. By law, local gasoline must contain at least 20% ethanol. Ethanol already accounts for a third of gasoline volume sold there, ten times the ratio in the U.S. Because sugar cane yields far more ethanol per acre than corn does, Brazil is a much-lower-cost producer of the biofuel.

You can play Brazil's ethanol market through Petrobras (PBR), whose shares trade in the U.S. as American depositary receipts. The company doesn't produce ethanol, but as the nation's dominant oil refiner and the largest gas-station operator, Petrobras is the world's largest purchaser of ethanol. Lucas Mello, an investor-relations official for Petrobras, notes that the company distributes ethanol-blended gasoline to customers such as Shell and ExxonMobil. Mello thinks Petrobras will eventually become a huge exporter of ethanol to energy-hungry Japan, China and India. The cheapest of the four stocks mentioned here, Petrobras trades at six times estimated 2007 earnings.

Key players: Four companies that are big in biofuels

Despite all the hoopla surrounding alternative energy, the four stocks listed below are not particularly expensive, and one, Petrobras, looks to be dirt-cheap. Only Avenine Renewable Energy is a pure play on biofules, and it's uinquestionably the riskiest of the four stocks.

Data to September 18. *Based on 2007 estimated earnings. **Based on fiscal year ending June 30. Source: Thomson Financial, Yahoo.