Pacific Ethanol Bounces on Rollover of Excise Tax Credit: More Good News Still to Come

| About: Pacific Ethanol, (PEIX)

As we began moving into the winter period, ethanol stocks went through a period of difficulty on concerns that the industry’s crucial excise tax credit would be allowed to expire on December 31st. Pacific Ethanol (NASDAQ:PEIX) was hit particularly hard, falling from around $1.10 in mid-October to 60 cents in early December – a full 45% decline in just under two months. The ethanol industry’s support measures have now been extended for another year. However, PEIX has only recovered to 72 cents and looks to have further to bounce. This is particularly true as there seems to be reason to believe that more good news may be on the way.

The measures themselves of course relate to the 45 cent per gallon tax credit available to producers of corn-based ethanol and the 54 cent per gallon tariff applied to imported ethanol. Both have been rolled over as part of the $858bn tax package signed into law last week.

With these support measures now secured, the market should now to able to re-focus on the positive news for ethanol producers related to recent announcements from the EPA. Back in October, the EPA announced that it would allow up to 15% ethanol to be added to gasoline to create an E15 mix available to be used by cars built since 2007. Currently, up to 10% Ethanol is added to gasoline and that mix (E10) is usable by all cars. Cars from the year 2000 or older will not be allowed to use E15 and a decision will be made in January on its use for cars built between 2001 and 2006.

The issue has been that since ethanol burns hotter than gasoline, it can cause the catalytic converters in cars to break down faster, possibly leading to unwanted tailpipe emissions. However, the oxygen sensors in newer vehicles avoid this problem by allowing combustion to adjust. The EPA has satisfied itself that models from 2007 at least can handle this issue. Some have worried that air quality may be affected if users inadvertently use E15 in older cars. However, the driving public can read labels and will no doubt work out which fuel is applicable for their cars, as we all do with regard to the different octanes available.

There have also been question marks surrounding the extent to which refiners and retailers will push E15. However, with the ethanol subsidy rollover in place, there seems to be a good chance that it may be followed by an announcement by one or more of the gasoline refiners/retailers that they will make a 15% ethanol mix available at the pumps. Since the announcement from the EPA that they will allow E15 for cars made since 2007, the major players have not shown any enthusiasm to move ahead with it. If that was to change it would be a major benefit to ethanol refiners. Valero is one player who has made a serious commitment to ethanol, having purchased some production facilities in the midwest and could be one of the first to move on this.

The use of ethanol as an alternative fuel has of course become controversial. I will write more about the carbon footprint issues involved with Ethanol in a separate article to follow.

However, for now, let me make two points –

  1. Firstly, amongst the supporters of alternative energy there are those committed from a climate change point of view and those more committed from the point of view of national security and the need to remove oil’s role in the world as a critical commodity. Clearly, the greater use of ethanol at the nation’s pumps suits the objectives of the latter group more than it does the objectives of those with more of a climate change orientation, who as a group are split on the issue. However, it is clear that if we are going to get anywhere on alternative energy these constituencies need to find a way to unite around some kind of program involving compromises. Ethanol is one we could give to the national security lobby – perhaps in exchange for solid support on a Federal Renewable Energy Standard, which would ensure that Utilities move electricity generation over towards greater use of renewables. In the absence of a clear national policy agenda, we need to cut and paste with what we’ve got, however imperfect that may be.
  2. Secondly, biofuels have a very promising future in alternative energy. Corn ethanol will eventually be replaced by more efficient cellulosic ethanol and perhaps lipid producing algae and other alternative fuel processes. To support this path towards development what we need is for retailers to put the infrastructure in place to allow the distribution of alternative fuels – and of course the production of new cars, built in compliance with an Open Fuel Standard. It is estimated that it would cost little over $100 to the production cost of an ordinary car to produce it with an engine designed to deal a variety of fuel choices – and particularly with a higher concentration of the more corrosive ethanol.

The final objective would of course be PHEVs which run off lithium batteries, with back up range-extending secondary engines which run off an Open Fuel Standard – allowing them to deal with a range of fuels from gasoline where necessary to E85 Flex Fuel (85% ethanol) and in the future other alternative fuels. The consumer would then be in a position to refuel as he wishes.

The point, however, is that in order to both ensure the roll-out of more production models that can deal with Flex Fuel and the greater availability of alternative fuels at the pumps, we need a bridge fuel to keep the process moving whilst the more efficient cellulosic ethanol mixes and other products are being developed.

Though there are many difficult issues involved, this probably means that we need corn-based ethanol for now. It’s a compromise but it can take us further down the road to the objective we need.

With those objectives in mind, Pacific Ethanol now looks like an unloved, beaten down stock worth buying. And if the market is given a sign that refiners and retailers will indeed embrace E15, then there is room for a decent bounce back.

Disclosure: I am long PEIX.

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