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The twisted, tortuous tale of ethanol as the great hope for an energy-independent America holds an object lesson for us all. What I wrote in my most recent article for SA, on a different subject, holds equally true here:

Entrepreneurs make money; early investors make money; and later investors make money if the business model is a good one and is able to adapt to changing conditions. But bureaucrats and politicians? They take money, they don’t make it! By the time a light bulb goes off over their heads to ride a successful wave, the wave has passed, friends. And they are left out at sea, after dark, with some mighty hungry sharks.

That’s exactly what happened with ethanol. Politicians and bureaucrats decided, against the advice of many geologists, ecologists and biologists who understood these things, that they needed to “do something.” It didn’t have to be the right thing as long as it made them look like they were "taking action." They swallowed and then regurgitated enough bad information to fool themselves and the rest of us, but long after the rest of us have caught on, they are still unwilling to admit they were wrong. There may have been some good intentions here but, like the man said, “The road to hell is paved with good intentions.”

To begin, what is ethanol? It is basically a combustible alcohol made from plant material. It’s been used almost since the first Model Ts rolled off the assembly line but it didn’t catch on big-time until Your Government at Work decided to massively subsidize its production, using tax dollars to pay for subsidies to develop ethanol rather than something deemed less important like, say, fixing crumbling bridges or cleaning up government-agency pollution.

Ethanol for our cars can be mixed with gasoline in concentrations up to 10% without any modification to the drive train. Anything higher than this concentration, you’ll need to modify the engine or risk engine damage because of the higher corrosiveness of ethanol.

In Brazil, most cars are designed to run on a 25% ethanol / 75% gasoline (“gasohol”) blend. But this just goes to show that a solution in one place is not always readily transported to another. In Brazil, they make their ethanol from sugar cane which takes about 1 unit of sugar cane, production and human labor energy to produce 8 or more units of ethanol energy. Sugar cane grows like a weed along the equator and in the tropics. The sun does 90% of the work – the only energy we need to add is to fertilize, harvest and process the stuff.

In the US, however – farther from the benevolent equatorial sun – it takes 1 unit of crop cultivation and labor energy to produce just *1 to 3* unit of ethanol energy – and that doesn’t include transporting it from processing plant to end user. Instead of sugar cane, Americans typically use corn as our crop for energy. We are using a plant that has cash-crop value and could be sold for its nutritional value instead of converting it to energy for transportation. This results in a huge diversion of agricultural land from food production – and one that typically uses large amounts of scarce fossil fuels to power the ethanol production plants and beyond-common-sense amounts of water to process it.

Proponents like to say that we are currently only at step one, however, and the ideal, once we can figure out how to break it down to a usable liquid form, is to use the residue left in the fields after the edible corn has been harvested for food – the stalk, husk, leaves, and cob (collectively called the “stover”). Or to use the chaff left over after wheat is harvested, or trees specifically grown for use in ethanol production, or native prairie switchgrass or some other fast-growing weed. The problem is, no one is yet able to do this outside the lab (“But with enough grants and subsidies we think we could, honest!”)

On the good side, ethanol is at least easily transportable -- using fossil fuels to do so, of course. We can’t use existing oil or gas pipelines because of the corrosive nature of ethanol. So to figure the economics of ethanol honestly we’ll have to take into account the energy needed to mine and fabricate the new metals needed and the labor to transport them and lay them into the ground and maintain them if ethanol is to be anything but a hobby for Congressmen buying votes from farmers. Also on the good side of the ledger, if/as we figure out how to break down this tougher cellulose sometime in the future, cellulosic ethanol would have a lesser environmental impact than current fossil fuels.

On the bad side, ethanol’s energy density is about half that of the fossil fuels so it will require twice as much of the stuff to get the same bang for the buck. And until we can figure out cellulosic ethanol production, the sugar and corn we currently use will remain at higher prices than they would if the only demand was for food use. Remember when ethanol first caught on big in 2007? The price of corn tortillas, a dietary staple in Mexico, rose 400%. As the brilliant American microbiologist and ecologist Garrett Hardin once said, “We are limited by the basic theorem of ecology, ‘We can never do merely one thing.’ "

Unintended consequences lurk in every decision, even those well- and slowly-considered -- which this, of course, was not. Ethanol and other biofuels now consume 17 percent of the world’s grain harvest. If we continue to clear land of native vegetation to create “fuel crops” we risk releasing far more CO2 into the atmosphere (estimates range from 10 times more to 400 times more) than if we just stuck with extracting fossil fuels and used nuclear, hydro, geothermal, wind and solar as supplemental sources.

There is the further problem that corn ethanol uses 3 to 6 gallons of water for every gallon of ethanol produced. Water may be abundant and cheap today but it is an increasingly scarce resource the value – and price – of which can only go up. (See here for more on water usage and scarcity.)

Finally, the prospects don't look to improve. We are currently “growing” ethanol in the ideal environment -- in the American Heartland. If this is to be anything but a subsidy program for corn farmers, we must bring on significantly more production to meet the demand. And, while the economics currently don’t justify use of the product without subsidies, the economics get even worse as we expand beyond the optimal soil and climate conditions of Iowa and Nebraska. We cannot duplicate their environment in Oregon or Florida, so as we expand to less-ideal areas, yields will decrease -- and prices will rise.

So – what’s an investor to do? If you are invested in Brazilian ethanol producers, I say you might stand a chance. But in the US, I believe that ethanol faces a dim future except in “pork production” as politicians bring home the bacon by taking dollars from one set of citizens and giving to those in their home district. Ethanol is a product that uses nearly as much energy to make as it provides, and gulps precious water from aquifers to boot. It is a “hobby” fuel, unlike, say, natural gas and coal.

While seeking to harness genuinely renewable energy resources, we should not eschew the giant “batteries” Mother Nature has kindly placed under the earth and sea in the form of natural gas, coal, and (less and less in the USA) oil deposits. These are the absolutely most efficient forms of energy in terms of what it takes in dollars and energy (fuel and labor) to get to them versus the amount of energy they provide for those dollars and energy.

Dr. Charles Hall, professor of Systems Ecology at Syracuse, created the following to demonstrate, in one diagram, a snapshot of the Big Picture for US energy sources, usage and costs.

The vertical axis, titled “EROEI” (Energy Returned on Energy Invested) represents the ratio of net energy gained by finding and using a particular energy source. The horizontal axis shows the quantity used in the US as of 2005.

The “domestic oil” balloons connected by arrows are quite telling. They show that, around 1930, when the United States used about 5 quadrillion BTUs of oil for energy, we got a 100:1 return on our investment. That is, the labor, transportation, materials and energy used to get domestic oil cost one unit but provided 100 units worth of energy value. Cheap oil from easy-flowing big fields fueled our industrial might in those early years. But by 1970, even though domestic oil provided 5 times as much energy -- some 25 quadrillion BTUs -- we were only getting a 30:1 return on our energy inputs. And by 2005 domestic oil energy production provided somewhere around 15 quadrillion BTUs a year and our energy in / energy out returns had plunged to just 15:1.

Three other notes about Dr. Hall’s diagram:

The size of the balloon doesn’t represent percentage of use but rather the uncertainty factor in trying to assess all the variables involved in bringing a particular energy source to actual usage. So coal, for example, has so many different extraction, transportation, and labor variables that the chart reflects two facts: coal provides an energy return on energy invested of somewhere between 45:1 and 85:1 – and it provides 30 quadrillion BTUs of energy a year,roughly the same amount of energy as imported oil does.

The shaded area at the bottom of the diagram represents Dr. Hall’s estimate of the minimum EROEI required to sustain our industrial society. If you get much below a ratio of 5:1 or 10:1 you enter a danger zone where economically marginal nations and consumers of energy say, “We can’t afford it. We’ll just gather firewood and cow dung until that’s all gone and then starve or depend on the kindness of strangers.”

And finally, the “total photosynthesis” line 2/3 of the way to the right expresses the total amount of solar energy captured annually by all the green vegetation in the U.S. -- forests, fields, swamps, lawns, whatever. Regrettably, however, the amount of that energy currently captured by photovoltaics is pegged at the far left, close to zero down in the shaded area, and at one of the worst net returns on energy invested.

Looking at all this, I am ever more convinced that the money to be made as investors this year or this decade, rather than in our children’s or grandchildren’s lifetimes, remains in fossil fuels. It is therefore primarily in the politically-stable and relatively transparent US, Canadian and Australian natural gas and coal companies that I am putting my money and that of our clients.

The US and Canada mostly supply the world’s largest consumers of energy – that would be Americans. Australia is geographically almost next door to the #2 and #3 consumers of energy, China and Japan, with India coming on strong. I have written extensively on this subject so you may peruse previous articles if you care to (the most recent on this subject are here and here).

The logic of why we own what we do has already been stated in those previous articles, so I’ll just mention a few of the explorers, producers and transporters that we are long and invite you to do your own research to see if you agree with our conclusions:

  • Among the explorers and producers, we are particularly impressed by Encana (ECA), Imperial Oil (IMO), Exxon Mobil (XOM), Conoco (COP), Royal Dutch Shell (RDS.B), and Chesapeake (CHK).
  • Among transporters and pipeline firms, we own Magellan Midstream (MMP), Boardwalk (BWP), Enbridge Energy (ENB) and its US subsidiary MLP, Enbridge Energy Partners (EEP), Kinder Morgan (KMR), Buckeye (BPL), Enterprise (EPD) and Teekay Offshore (TOO).
  • Our favorite Canadian energy royalty trusts include Enerplus Resources (ERF), Pengrowth Energy (PGH), Provident Energy (PVX), Penn West (PWE), and Harvest Energy (HTE).
  • In coal, we prefer two coal royalty firms that buy coal-bearing lands then lease them to the big operators -- Natural Resource Partners (NRP) and Penn Virginia Resources (PVR). Also in coal, we like the world's largest producer of synthetic fuels, both coal-to-liquids and gas-to-liquids. That company is Sasol (SSL). Since 3 of the world’s top 4 energy consumers hold the most coal reserves (The U.S., China, and India) we see SSL’s technology as having quite a sustainable market.
  • Finally, for those who prefer the diversification of ETFs and Closed-End Funds, you might take a look at Market Vectors Coal (KOL), PowerShares Global Coal (PKOL). iShares MSCI Australia Index ETF (EWA), iShares MSCI Canada Index ETF (EWC), CurrencyShares Australian Dollar Trust (FXA), CurrencyShares Canadian Dollar Trust (FXC), Wisdom Tree Dreyfus Emerging Currency Fund (CEW). Gabelli Global Gold, Natural Resources & Income Trust (GGN), Enbridge Income Fund (OTC:EBGUF), and First Trust ISE-Revere Natural Gas Index Fund (FCG).

Personally, I’d rather have a small piece of pie right here on the ground than waste my time and money reaching for that great big pie in the sky…

Author's Full Disclosure: We and clients for whom it is appropriate are long some or all of the above securities.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: We do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Also, past performance is no guarantee of future results, rather an obvious statement if you review the records of many alleged gurus, but important nonetheless –our Investors Edge ® Growth and Value Portfolio has beaten the S&P 500 for 10 years running but there is no guarantee that we will continue to do so.

It should not be assumed that investing in any securities we are investing in will always be profitable. We take our research seriously, we do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Source: Ethanol vs. Natural Gas or Coal: Comparison Not Even Close