Will Congress End Ethanol Subsidies?

Will Congress Finally Kill Off Ethanol Subsidies?

The Surprising Effect on Biofuel Stocks

Building Your Biofuel Watch List

Ethanol has been a fuel for automobiles from the start of the industry. In 1896, Henry Ford built his first car, the Quadricycle, to run on ethanol. His Model T, which revolutionized auto manufacturing when it rolled off the assembly line in 1908, was designed to run on ethanol or gasoline. Even as Ford continued to push for ethanol from corn as the logical fuel, lower priced gasoline won out.

The oil shocks of the 1970s revived the idea of ethanol as an alternative fuel, and the corn-based version is now blended into 90% of the gas Americans use every day. Ethanol received a further boost when it was discovered in the mid-1990s that MTBE, a gasoline additive meant to raise gasoline’s octane as an anti-knocking solution, was found to have widely contaminated groundwater when it spilled.

The U.S. government has stimulated ethanol’s use with a hearty 45-cents per gallon subsidy that it grants to ethanol refiners, and a 54-cent tariff imposed on imported ethanol. Under the renewable fuels standard that is in place, gasoline refiners must blend at least 12.6 billion gallons of ethanol into gasoline this year. The taxpayer tab in 2011 for ethanol subsidies? $6 billion.

Ethanol has an indirect cost too: This year, 40% of the U.S. corn crop–which in turn represents 5% of the world’s grain crop–will go to ethanol. This is one of the factors that contributed to corn hitting its highest price ever–$8 a bushel in June. There are other complaints about ethanol too: Antique car collectors tend to believe the presence of ethanol accelerates the corrosion of their engines (newer cars are designed to deal with the ethanol mix just fine). More than one pipeline owner refuses to allow ethanol to be transported through its pipelines because of fear that ethanol will corrode pipes.

No doubt there was a place for ethanol subsidies at one point, but I think it’s foolish to pay billions of dollars to support a fully developed industry when we’re suffering from a fiscal crisis. There are many arguable downsides to ethanol supports, not the least is an effect on raising food prices (although other factors like an awful world crop year last year and booming Asian demand for cattle feed are also significant in corn’s price rise too).

Surprisingly, it seems Congress, long the defender of ethanol, is prepping to end the subsidies. Maybe.

In June, various reports indicated that Congress had reached a bipartisan deal to eliminate the subsidies in July in a bid to narrow the current deficit by a billion or two. True to form, Congress didn’t end up actually doing anything on the deal, opting to go on August vacation instead. But ethanol industry players expect that Congress will let the subsidies and tariffs expire as scheduled at year’s end. There’s good reason to: Under rising ethanol blending mandates, it is estimated the subsidies as structured will cost taxpayers $54 billion through 2015. Don’t bet on it just yet–there was a lot of expectation that Congress would let the subsidies expire last year too.

Setting subsidies aside, there is a strong argument to be made that ethanol’s inclusion in the fuel mix lowers U.S. gasoline demand and therefore gasoline prices. A 2008 University of Iowa study estimated ethanol kept gas prices 20 cents a gallon lower (or more) by lowering gas demand. Removing the tariffs on imported ethanol should also lower ethanol prices and allow cropland to be used for food–not fuel–in turn easing global food prices. A federal study last year found a net savings in carbon impact versus gasoline (albeit relatively small), which in turn has environmental benefits.

Of course, the uncertainty of subsidies places a big question mark before those looking to invest in the biofuels industry. Somewhat surprisingly, the major ethanol refiners in the U.S., Archer Daniels Midland (ADM), Valero (VLO) and The Andersons (ANDE) haven’t suffered much: ADM and The Andersons have actually performed slightly better than the broad market since June (both have notable non-ethanol business lines benefitting from corn’s price strength), while Valero, which is a significant gasoline refiner, has been weaker than the market of late because gasoline refinery maintenance has taken some capacity off line this month.

While each would take a hit from the elimination of ethanol refining subsidies, they still have the financial heft to stay afloat and meet the growing ethanol blending mandates that don’t appear to be going away. Earlier this year, the Environmental Protection Agency approved using a 15% ethanol blend in gasoline for cars made in 2001 or after.

But younger biofuel stocks haven’t fared nearly as well. Codexis (CDXS), which makes catalysts for ethanol and biodiesel production and for pharmaceutical production, has fallen from 11 in May to 6 at the beginning of August. Amyris (AMRS) and Gevo (GRVO), which each make renewable substitutes for petroleum-based fuel products, have each fallen 50% since the early spring. There is a lot to like about each of the three companies, but they are better watched than bought right now. My suggestion is to wait for the market–and especially oil prices, which hold sway over the business models of alternatives–to find their equilibrium.

If you’re looking to build a watch list of stocks to buy sooner rather than later, I suggest looking at some of the companies that are performing well in Brazil’s robust ethanol market. As the world’s second-largest ethanol producer after the U.S., Brazil producers would benefit from removal of the three-decade old 54-cent per gallon tariff on ethanol imports. Cosan (CZZ), in particular, is worth taking a closer look at.

Cosan, one of the larger, more established companies in Brazil, was founded in 1936 as a sugar cane producer. In 1976, when Brazil jumped headlong into ethanol production by requiring a blend of up to 22% of ethanol in gasoline, Cosan became one of the leading makers of the fuel. Today, many Brazilian vehicles can run on pure ethanol, helping cane-based ethanol now command 50% of the auto fuels market in the country. Cosan has expanded with ethanol’s influence, buying up ExxonMobil’s (XOM) retail filling stations business in 2008.

Last year, Cosan entered a 50-50 partnership with Royal Dutch Shell (RDS) in a new company, called Raizen, to produce ethanol, sugar and power (by burning cane husks) from sugar cane. In its latest quarter, reported last week, Cosan’s sales grew 25% to 5.19 billion reals (equal to $3.3 billion) with a net profit of 2.3 billion reals ($1.5 billion), although the bulk of that eye-popping net profit came from accounting for the merger of a number of company assets into the Raizen venture. Setting that aside, profit would have been a lot less, at $106 million.

It is Raizen that makes Cosan worth considering. The new company will produce 528 million gallons of cane ethanol a year, 9% of Brazil’s demand, and distribute them through Shell’s retail network in Brazil. Shell expects the global demand for low-carbon biofuels like ethanol (and cane-based ethanol is believed to have a lower carbon footprint than corn ethanol) to triple worldwide by 2030 … and for Raizen to grow with it.  Should the ethanol tariffs expire at year’s end, it’s a good bet that a lot of Cosan’s and Shell’s growth will come from exports to the U.S.

Sincerely,

Brendan Coffey
Editor of Cabot Global Energy Investor

Editor’s Note: Brendan Coffey is the editor behind Cabot Global Energy Investor, which selects the top energy stocks each month and combines them with Cabot’s proprietary market timing indicators to score winning results for subscribers. With ethanol subsidies possibly on the way out and oil prices rocketing around, now is THE time to profit from the top stocks in this sector. Learn more now!

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