Ethanol's Long-Term Prospects Bolstered by E15 Approval

by: Clumsy Rick, CFA

Thursday, the EPA approved the use of up to 15% ethanol in gasoline (E15) in vehicles produced during 2001-2006. Last fall, the EPA approved E15 for vehicles made in 2007 or later so, in total, E15 is approved for about 2/3 of the vehicles on the road today. Currently, ethanol is blended into gasoline at a 10% rate (E10), so the E15 approvals represent a potential 33% increase in ethanol demand over time.

The impact on ethanol demand, however, will not likely be felt anytime soon. Even after the EPA comes out with the necessary pump labeling schemes to prevent mis-fueling (i.e., using E15 in vehicles made before 2001 or for boats and other small engines), there is substantial resistance from gasoline retailers to carrying this fuel. The primary reason for this resistance appears to be that adding E15 would mean having to remove some other fuel grade since the pumps are limited in the number of choices they can offer. So while the resistance would have likely been insurmountable without Thursday's announcement, there are still many issues to work through before E15 is widely adopted.

Over the medium and long term, however, this is clearly a bullish sign for the industry as the EPA approval is a positive sign of support for ethanol. Further, it provides tremendous momentum for industry efforts to drum up government support on new infrastructure in exchange for allowing blender tax subsidies to end when they expire at the end of 2011. Infrastructure investment should include adjustable fuel pumps which allow consumers to choose the blend of ethanol they want, including E10, E15 and E85 (for flex-fuel vehicles). Industry tax subsidies have been unpopular in Congress, but infrastructure investment has a much stronger fundamental argument as it would truly expand the use of ethanol, ensuring a market for more desirable cellulosic and other advanced biofuels under development.

BUY Rex American Resources (NYSE:REX)

My favorite recommendation in this space is REX. Even if you still have major concerns about the future of ethanol (and I do think the risks are still high), REX is an extremely low risk-way to play it. As I have written previously, Rex is trading well below the book and market value of its assets, even assuming liquidation of its ethanol plants, and the company has substantial cash and real estate assets. In buying REX near $15 a share and subtracting out the value of these assets, you are getting potentially valuable ethanol assets (ownership interest of over 200 million gallons/year production) for nearly free.

Disclosure: I am long REX.