The Rise of Green Fuel

by: Hard Assets Investor

By Daniel Harrison

It's already axiomatic among investors: When oil runs out, alternative energies, like solar or wind power, will help pick up the slack. But those looking to diversify their green portfolios should also keep a close eye on the next stage of clean tech investment: alternative fuels.

In recent years, a band of small- and medium-cap alternative fuel producers have emerged, prompting investors to rush into these high-risk, high-reward offerings.

But alternative energy and alternative fuels are completely different investments, fundamentally driven by two separate commodities: namely, oil and gas. And it's that distinction that holds the key to the clean fuel revolution.

Clean Energy Vs. Clean Fuel

Despite the flurry of alt-energy ETFs launched lately, most options for alternative fuel investing are still the individual companies, which tend to be high-risk, small- to medium-cap firms.

In some ways, this isn't so bad. Take the PowerShares WilderHill Clean Energy ETF (NYSE Arca: PBW), the PowerShares CleanTech Portfolio (NYSE Arca: PZD) and the First Trust NASDAQ Clean Edge Green ETF (NASDAQ: QCLN). These three ETFs - which straddle the range of small- to large-cap funds - have performed reasonably well this year (they're up between 20-25%), but they still lag the stock market as a whole. In part, they've been dragged down by under-performing sectors like solar: First Solar, a $10 billion solar power leader, has dropped 9% year-to-date, while Evergreen Solar, a smaller provider, has plunged 41%.

But the story could not be more different for synthetic fuel makers. Synthesis Energy Systems (NASDAQ: SYMX), which uses gasification technology to convert coal and coal waste into clean transportation fuels, has surged 79% year-to-date. Rentech (AMEX: RTK) has skyrocketed 240%, after recently receiving a contract to supply 1.5 million gallons a year of synthetic diesel fuel for eight U.S. carriers, including Delta Airlines and American Airlines, starting in 2012. And Syntroleum Corp (NASDAQ: SYNM), a biodiesel manufacturer, is up a whopping 430%. (For more on alt-fuel deals, check out our recent story, "Exxon: A Biofuel Bet?".)

The reason for the disparity between clean energy and clean fuel, says Art Hogan, chief market analyst at Jefferies & Co., is that clean energy companies require high natural gas prices to flourish, while fuel makers need high oil prices - a distinction many investors fail to make.

"There is a misconception that clean tech is, in general, tied to the price of oil, and that there is a $75 hurdle rate [to profitability]," Hogan told Hard Assets Investor. "But you can't look at $75 oil and say that we're back in the clean tech business. Until we see natural gas prices move, clean energy companies will continue to move in the wrong direction."

Hogan expects solar and wind power companies to continue to under-perform over the next 12 months, until the price of gas begins to rise again.

When that will happen is still up for debate, as it depends heavily on the recovery of U.S. consumption. As the recession has hit, so has the price of natural gas fallen: On Friday, it reached a low of under $3 per thousand cubic feet vs. $13 per thousand cubic feet a year ago. (Still, for investors with positions in ETFs such as the United States Natural Gas Fund (NYSE Arca: UNG) or the SPDR S&P Oil & Gas Exploration & Production ETF (NYSE Arca: XOP), investing in beaten-down solar power companies or green energy ETFs right now could make for an interesting addition to a portfolio, whenever prices begin to rebound.)

The Two-Way Bet

Investing in alternative fuel is really a two-way bet: Companies will be able to produce their fuel at a commercial capacity and the oil price will hold at current levels, says Pavel Molchanov, an analyst at Raymond James. Molchanov upgraded Rentech this week to "Market Perform" from "Underperform,"

"We are in a commodity rally, which obviously benefits Rentech. With $70 oil, it goes without saying that the economics of producing synthetic fuel is more competitive than with $50 oil," Molchanov told Hard Assets Investor.

"Conceptually, I can understand the interest in alternative fuel, since a lot of world's consumption for energy is in transportation, as opposed to just electricity," he added.

But Molchanov points out that despite the tough times right now for solar and wind power companies, their growth curve and economic opportunity is "much more visible" than for alternative fuel companies, whose "best-case scenario" for supplying their products on a commercial scale is still around three years away.

Another problem for alternative fuel providers lies in the commodities used to create their synthetic product. Even if oil does return to its previous highs of $150 a barrel, if the price of the commodity the company uses to manufacture its fuel also begins to rise substantially, then their profitability sinks. In the case of Synthesis Energy Systems, for example, China's insatiable demand for coal could force prices up, thus squeezing the firm's profit margins.

How To Play Alternative Fuels Safely?

Perhaps the most obvious way for investors to take advantage of the general commodities rally, while still hedging their bets in the green tech sector, would be to buy a little bit of everything. Combining an investment in a clean fuel company alongside one in the commodity it uses to manufacture its product (as a hedge against the firm's costs), plus a small position in a natural gas ETF, exposes a portfolio to multiple scenarios.

In fact, until the economy stabilizes, that may turn out to be the best way to realize steady gains without suddenly losing a pile of cash.