Archer Daniels Midland: The Ethanol Play

| About: Archer Daniels (ADM)

Next time you’re at the pump, take a moment to give a little nod to corn.

If it wasn’t for corn, the price of gasoline would be at least $0.17 a gallon higher (and possibly as much as $0.50 a gallon higher depending on which study you read). For another, according to the Renewable Fuels Association and the National Farmers Union, the ethanol produced from corn helped decrease U.S. foreign oil imports by 24 percent over the last five years.

For that, corn deserves a little praise… And it also means that investors have a way to cash in on an industry poised to double in the next five years…

The Largest Ethanol Producer in the World

The United States is the largest ethanol producer in the world. With more than 14 billion gallons of annual capacity, the United States came close to this market as it produced 13 billion gallons of the biofuel in 2010.

We produce more than half of the world’s ethanol. And U.S. ethanol exports hit a record 350 million gallons last year.

But we’re also the biofuel’s largest consumer, and growing. In 2010, the United States guzzled 13.1 billion gallons of ethanol. But with the Environmental Protection Agency (EPA) mandating that at least 8.01 percent of all vehicle fuels sold in 2011 must be biofuels, U.S. ethanol consumption will push higher again this year.

The Energy Information Administration (EIA) expects ethanol consumption to jump during this summer’s driving season from 868,000 barrels per day (bbl/d) to 912,000 bbl/d – making up approximately 10 percent of total gasoline consumption.

But compared to what’s on the horizon, this is just the beginning. By 2022, it’s government-mandated that domestic production of ethanol reach 36 billion gallons per year.

Keep in mind:

  • 10 years ago the United States only produced 1.6 billion gallons of the biofuel. So that’s an 800 percent increase in just a decade.
  • Now, 90 percent of all gasoline sold in the United States has a 10 percent ethanol blend.
  • And the EPA cleared the way to bump that to 15 percent for 2011.

Ethanol’s Laundry List of Perks

Ethanol is a unique commodity.

In addition to its government-mandated use, companies also receive a $0.45-per-gallon excise tax for blending ethanol into gasoline. The excise tax is often a contentious issue since the government doled out $6 billion in 2010 for the incentive (it’ll amount to roughly $6.25 billion in 2011 due to increased production). But the other side is that ethanol sales brought in $11 billion in tax revenue for states and the federal government last year.

And it’s saved the U.S. economy another $36 billion by reducing foreign oil imports.

But the U.S. government goes a step further to safeguard domestic ethanol production and use: A hefty tariff of $0.54 per gallon on all foreign imports. This basically kills any overseas competition (because the excise tax applies to any ethanol blended into gasoline, regardless of country origin).

It’s a three-pronged privilege no other industry receives. And just another part of the long-standing tradition the U.S. government has of giving domestic farmers as many advantages as possible.

NYSE: ADM – A Corn-Fed Powerhouse

Senators tried to lower the Volumetric Ethanol Excise Tax (VEETC) credit in December and failed. So the likelihood of it being killed outright seems a little far-fetched at the moment because of the trade-offs and the government goals… But $6 billion is $6 billion. And outside the ring of corn-producing legislators, the tax credit’s favor is waning. Though it’s still in place until the end of this year.

Obviously, the VEETC will have to be done away with at some point. I mean, by 2022, it would carry a price tag of $16.2 billion. And Brazil has already eliminated its own ethanol tariff in hopes that the United States will do the same and make the global market more competitive.

For investors, the top-dog in the blossoming U.S. ethanol sector is probably a company you wouldn’t expect. Because it’s not an oil or gas major, but Archer Daniels Midland & Co. (NYSE: ADM) is far and away the king of the hill, producing over 1.7 billion gallons of ethanol per year. That’s 4.5 times more than its second-largest competitor, Abengoa Bioenerg (OTCPK:ABGOY). And not only is ADM producing ethanol from corn here in the United States, they’re also producing ethanol from sugarcane in Brazil – the world’s second-largest ethanol consumer.

ADM is scoring big with ethanol too. In the second quarter, profits in the company’s bio-products division surged 135 percent due to higher ethanol margins and volumes.

The Price of Ethanol in the United States

You see, the price of ethanol in the United States is still below its peak in 2006. But it’s been on a steady incline since January 2009, rising 54% to $2.58 per gallon.

ADM is positioning itself to capitalize on surging global demand for biofuels. By 2020, the world’s thirst for biofuels, like ethanol, will increase 133 percent. And projections are actually for an ethanol supply deficit of as much as five billion gallons by then. That means global ethanol supply shocks similar to what we saw in Brazil earlier this year when ethanol prices surged to record highs.

With oil over $100 per barrel and the price of gasoline nearing $4 per gallon, expect the spotlight to get brighter on alternative fuels. The biofuels industry is still evolving and in its infancy commercially. The best part is that companies like ADM are well-diversified and insulated against any price volatility – or reduction of tax credits – that might plague their competitors.