Abandon U.S. Ethanol in Favor of Natural Gas

by: Mike Maher

As central banks around the world continue to monitor inflation from rising food and energy prices, it is becoming increasingly clear that current U.S. policy, both fiscal and monetary, is not doing enough to address higher prices. The federal government's mandate of ethanol production distorts both the food and fuel markets, and is bad for consumers around the world. As food prices continue to move higher, natural gas prices bounce along the bottom, driven down by massive reserves of the fuel being accessed from shale formations across the U.S. A shift in U.S. federal government incentives, from protecting an inefficient ethanol industry to supporting natural gas as a transportation fuel, would not only lower food and fuel prices, but could open up new areas of trade and increase U.S. competitiveness in the global marketplace.

To be clear, I am not against ethanol as a transportation fuel. Brazil has shown that ethanol can be used to provide a reliable fuel with stable prices, in case there was any doubt from skeptics such a feat was possible. However, Brazil produces its ethanol from sugarcane, rather than using corn as the fuel source. The sugarcane to ethanol production process is more efficient than turning corn into ethanol, making the fuel cost less in Brazil. In order to help the U.S. ethanol industry survive, the federal government has had to distort the natural prices of the fuel. First, there is a $0.45 per gallon subsidy paid to all companies who blend ethanol with regular gasoline, lowering the cost to produce the E85 fuel mixture the U.S. government is pushing. Secondly, there is a $0.54 per gallon tariff on ethanol coming into the U.S. Both these interferences prevent U.S. consumers from benefiting from lower prices of foreign ethanol, while rewarding U.S. ethanol companies and oil refiners with subsidies to keep the industry thriving. The U.S. ethanol industry will use 5 billion bushels of corn this year, compared to a total harvest in 2010 of about 12.4 billion bushels. The industry's growth, in addition to increasing demand for better quality food from populations around the world, is adding pressure to corn prices, which are trading near all time highs. The U.S. ethanol tariffs and subsidies are not only supporting higher prices for ethanol, but are driving up the cost of food by encouraging the use of corn for ethanol.

The abundance of natural gas being produced in the U.S. has given the country a problem every country in the world would love to have: what will we use all this low cost fuel for? Natural gas already has a minor use as a transportation fuel, although it is much more prominently used in homes and businesses for heating and cooking, as well as being used for power generation. T. Boone Pickens is the most vocal supporter of using natural gas as a transportation fuel, having lobbied (unsuccessfully thus far) for several years for the usage of natural gas in heavy trucks through the NAT GAS Act. The bill would provide incentives via tax credits to spur the purchase of trucks that use natural gas, rather than diesel, and to build out the infrastructure needed. The tax credits could range up to $84,000 for heavy trucks, and a tax credit for 50% of infrastructure costs, up to $100,000. The bill also includes a $0.50 per gallon credit on the federal fuel tax, and credits of up to $4,000 per vehicle for manufactures of both CNG and LNG vehicles. Current prices for CNG are around $2.50 per gallon equivalent in New York City and between $2.05 and $2.70 in the greater Los Angeles area, according to CNGprices.com.

Abandoning the support for the U.S. ethanol industry would cause a drop in corn prices as inventories were rebuilt, leading to lower food costs across the board as the price of this key input dropped. It would also open the U.S. up to import cheaper ethanol from places like Brazil, and greatly incentivize the U.S. ethanol industry to become more efficient and find a new fuel source to create ethanol. While abandoning this policy may not lead to lower fuel prices, the drop in food prices would cool inflation pressures greatly. Passing the NAT GAS Act would open up a serious competitor fuel to gasoline in the U.S., and would allow the U.S. to switch to a fuel that is produced domestically and is both cheap and abundant. The resulting decrease in oil demand would lower fuel costs for those not switching to natural gas, providing a benefit to the entire country and further decreasing inflation pressures.

As long as the U.S. continues its ethanol policy, corn and fertilizer stocks will benefit from the industry consuming so much of the nation's corn. Companies like Agrium (NYSE:AGU), Potash Corp of Saskatchewan (NYSE:POT), CF Industries (NYSE:CF) and Mosaic (NYSE:MOS) will all stand to benefit as high crop prices mean farmers have more income to spend on fertilizers. Deere (NYSE:DE) will also benefit as farmers worldwide spend on new equipment, as will Monsanto (NYSE:MON), the seed producer. Archer Daniels Midland (NYSE:ADM) would be a big loser should the policy be reversed.

Should the NAT GAS Act be passed, Clean Energy Fuels (NASDAQ:CLNE) would be a giant winner. The firm, founded by Boone Pickens, owns and operates fueling stations for CNG vehicles, and would not only see increased demand for its services but it also could cash in on the rich tax credits. Westport Innovations (NASDAQ:WPRT) provides the fuel systems for the natural gas engines in trucks, both alone and in partnership with Cummins (NYSE:CMI). Fuel Systems Solutions (NASDAQ:FSYS) also manufactures and supplies components and systems for the engines that would be used in new trucks. With the exception of Cummins, all three of these names react to headlines about this act with volatility, so none of them are for the risk averse. In addition, natural gas producers in the U.S., such as Chesapeake Energy (NYSE:CHK), Anadarko (NYSE:APC) and Devon (NYSE:DVN), will benefit from the firmer prices that new natural gas demand in the U.S. will bring.

Attempting to guess what legislation will become law and then invest on those assumptions is a dangerous game. There is no guarantee any legislation will pass, and those attempting to buy shares in CLNE or WPRT ahead of the NAT GAS Act passing have been disappointed over the last two years. I believe the federal government's policy on transportation fuels is helping to fan inflation, and that a logical reaction to rising fuel and energy prices would be to reverse course on ethanol and support natural gas. Turning food into fuel does not benefit the American public, since both need to be purchased. A shift in policy would be a good start in putting the U.S. on a path toward more stable prices and further energy independence, providing a tailwind for the U.S. economy and removing the headwind of inflation.

Disclosure: I am long CHK.