The substitution of alternative liquid fuels - ethanol and biodiesel - for petroleum-based gasoline and diesel fuel is a “fountain of youth” dream of clean, renewable resources replacing scarce, dirty ones. Is the dream practical? There are uncertainties because technology and the role of government subsidies and mandates will change. But there are clearly big differences between the two flavors, ethanol and biodiesel.
Corn ethanol is a tragic diversion from the important work of mitigating peak oil. It’s production does not yield much if any net energy gain; it is difficult to transport; it tends to attract and hold water which can ruin engines, and thus it can only be a gasoline additive, not a substitute; and when you finally get it into a gas tank, it produces only 75% of the power of gasoline.
The net energy gain of corn ethanol — the amount of energy ethanol yields compared with the energy required to make it — is disputed, but generally is considered to be only about 120% — or less. So for 100 units of energy input you get only 120 units out. Some think the ratio is actually negative. Others say processes can be improved and energy efficiency will improve.
In any event, U.S. corn based ethanol would not exist if it were not for the power of the U.S. farm lobby and the giant subsidies and mandates for corn ethanol that the farm lobby has achieved through its purchase of Congress. The result has been ethanol production that exceeds demand, low ethanol prices, and the cancellation of many plans for new ethanol plants. The stocks of companies in the corn ethanol business are currently selling for a fraction of the prices they once commanded, and I suspect they are still too high. Eventually the low energy efficiency of converting corn to ethanol will become understood by the federal and state governments, at which point its subsidies and mandates will be at risk. That could put this ill-conceived experiment to rest.
Cellulosic ethanol: The failure of corn ethanol puts in question the reputation of Vinod Khosla, a venture capitalist who is sometimes called a “visionary” in energy investing, but who — along with Bill Gates and thousands of mid-Western farmers — has bankrolled a lot of corn ethanol production. Khosla and some of his fellow ethanol investors are attempting redemption by moving into “cellulosic” ethanol.
Cellulosic ethanol is a fuel that would be made from wood chips and other plant material not used in food. Such inputs are less expensive than corn. They also use less petroleum and natural gas to grow and harvest than corn, and thus they have a greater net energy gain.
The problems with this idea start with the fact that cost effective cellulosic production technology is not yet proven. But even if the fuel can be made economically and with substantial energy gains, the output is still ethanol. Thus it will still have to overcome ethanol’s problems of difficulty in shipping, limitation of being an additive rather than a substitute for gasoline, and low mileage per gallon compared with gasoline. So the jury is out on cellulosic ethanol. I suspect that eventually it will have a place in the peak oil solution, but it will be an uphill battle.
Sugar-derived ethanol:Making ethanol from sugar works well in places like Brazil where appropriate land and weather are readily available. A way to invest in Brazilian sugar-ethanol is to own Cosan (NYSE:CZZ). It is a $1.7B sales, profitable company whose shares were floated in the U.S. in August, 2007, at $11 and currently sell for slightly less. CZZ shares could be more interesting if its exports grow because the price of energy products within the Brazilian market may stay low due to excellent diversification away from petroleum dependence. Brazil’s energy prices are therefore less dependent on the price of oil.
None of the problems of ethanol exist for biodiesel. It can be produced from low cost, non-food feedstocks like waste grease from commercial kitchens, the waste from meat and poultry production or waste oils from fish production. It can be mixed with traditional diesel for transport in pipelines or, potentially, piped by itself. It can be substituted for petroleum-based diesel in any amount up to 100%. Plus, diesel fuel of both the bio- and petro- varieties actually produces 25% +/- more power than gasoline for the same volume. Diesel is the dominant fuel in Europe and with the recent mandate for Ultra Low Sulphur Diesel [USLD] in the U.S., diesel is likely to take substantial U.S. market share from gasoline in the coming years.
Despite the advantages of biodiesel it is not yet being produced in scale. Total U.S. biodiesel production in 2005 was only 75 million gallons, a pittance. One reason is that the traditional production process for biodiesel has been limited to inputs like vegetable oil. As food inputs, they are not especially low cost feedstocks. In fact, some biodiesel manufacturers in Asia are now shutting down because the price of their palm oil feedstock has risen so much and its availability is now so limited.
A new process to produce biodiesel was developed six year ago by two brothers who were in the animal rendering business. The process allows for the use of 25 or more different feedstocks including some low cost “high free fatty acid” (“FFA”) inputs. It also claims to produce a superior quality diesel fuel output. (Yes, there are differing qualities of diesel fuel.) The process was bought by a group of former executives of large oil companies like Texaco and Halliburton who now operate the resulting public company, which is called Nova Biosource Fuels (NBF).
Nova has been developing and improving the original process. It has filed two process patents and has others on deck. It is assembling a production capacity that currently includes three plants with a total of 80 million gallons per year of biodiesel capacity. Some capacity is operating now and it is all scheduled to be fully functional by the end of 2007. The company aims to have 300 million gallons of capacity in three years.
NBF’s profitability will depend on the price of diesel and its costs of production which NBF believes will be less than half that of competitors because it uses low cost high-FFA feedstocks. It expects fully loaded costs to be in the range of $1.62 - $2.53 per gallon plus capital costs of about $1.25 per gallon per year of capacity or about $0.08 per gallon of depreciation. Federal and state tax benefits designed to encourage biodiesel production reduce those cost by $1.00 to $1.50 per gallon, depending on the state. So on the cost side, NBF could experience a theoretical low cost of $0.20 per gallon in a high subsidy state or a high cost of $1.61 per gallon, including the tax benefit. I would expect their costs to be on the high side initially and to gradually decline with production efficiencies, though probably not below $1.25 per gallon including the tax benefits.
NBF’s revenue is based on the “rack” (wholesale) price of diesel fuel. With oil in the $50 area rack rate was just under $2.00 per gallon in January, 2007. With oil over $90 now, it is about $2.75 and moving higher. From these numbers, one can project Nova’s gross margin on 80 million gallons of near term production capacity. Corporate overhead will run about $15 million per year. Fully diluted shares outstanding are about 140 million. Bottom line, NBF could be earning an annualized $0.60 per share, untaxed, at some point in early 2008.
The actual numbers should become apparent in the early part of 2008, perhaps in the March 31 numbers but certainly in June 30 numbers. It seems clear that if they are anywhere close to what is suggested above, a share price of double or triple the current $2.50 area could be justified. Moreover, once its true operating costs are known and once it puts together financing for its growth plans, analysts will be able to project earnings based on expanded production over the next few years. That suggests to me that the upside potential for the stock price is rather substantial.
The central concerns about NBF are the price and availability of feedstock and the efficacy of Nova’s proprietary production technology. NBF claims to have a feedstock supply agreement with ConAgra sufficient to let them produce up to 200 million gallons per year of biodiesel. On the other hand, the feedstock price is at “market”, so NBF seems to have little protection on the cost front. But both the price and the availability of feedstock eventually become a function of the NBF technology. To the extent that NBF can operate with high FFA feedstocks, its costs will be lower and presumably its feedstock availability will be greater because high FFA feedstocks are cheaper and more plentiful.
Thus far, NBF plants are ramping up their high FFA production, factoring in more and more high FFA feedstocks over time. Soy and other low FFA feedstocks are rated in the range of 3% - 8% FFE. NBF is now using up to 8% - 10% FFA’s, but they aim to use feedstocks with over 20% FFA. The ramp up is expected to last several more months. Thus, NBF should be operating at close to an optimal volume and feedstock mix starting early in 2008.
Incidentally, the output of biodiesel production includes a by-product, glycerin, which is used in making soap among other things. Recently it was announced that a process has been developed to convert glycerin into ethanol. So potentially the entire production output of Nova’s process could be turned into liquid fuels. Since profitability will vary principally with the price of diesel fuel, which depends on the price of oil, NBF is clearly a leveraged play on the price of oil.
Darling International, Inc. (NYSE:DAR) is a very different way to play biodiesel. Darling is a renderer and a collector of waste greases. Renderers collect waste fat and bones from meat producers and turn them into products. Both waste greases and animal fats are potential high FFA biodiesel feedstocks, although Darling presently is not using them for that purpose.
Darling could have two ways to profit from higher oil prices and growing biodiesel production. To the extent that it produces biodiesel feedstocks, higher oil prices should yield higher prices for their products and therefore, presumably, higher margins for Darling. Another option for Darling would be to integrate downstream into biodiesel refining, as the major oil companies integrated downstream long ago. It could joint venture with an existing biodiesel refiner (even, possibly with NBF) or it could build its own biodiesel capacity. As a producer of feedstock in an increasingly demand-stressed industry, Darling would seem to be an extremely attractive joint venture partner for an existing refiner. No doubt Darling would be able to leverage that attractiveness to achieve economic benefits.
Unlike NBF, Darling enjoys growing profits from its existing business model, which is independent of biodiesel production at present. Darling produces and sells a wide variety of food and non-food products from their rendering and grease feedstocks. Thus, biodiesel represents an opportunity for Darling to potentially improve its gross margins by turning its fats and greases into higher-priced biodiesel instead of the products it currently makes.
DAR’s $9 - $10 stock is not cheap on its $0.50 per share projected 2007 EPS, which are estimated by analysts to grow to $0.67 in 2008. But that base of operations provides more downside protection for the DAR investor than exists for the NBF stockholder, while still incorporating substantial upside leverage if the price of oil continues to rise and if and when Darling begins to sell into the biodiesel market.
In a sense, NBF is like a fuel refining company that is dependent on the margin between the price of its oil input and the price of its fuel output. Darling is (or may become) like the upstream oil producer. So in theory, Darling might profit more directly from higher oil prices because it has greater control of the feedstock. On the other hand, NBF seems to enjoy a technological advantage in the use of high FFA feedstocks and is already in the business of producing biodiesel. I believe both companies are potentially rewarding investments.
Finally, let us put some perspective on all this in terms of the size of global fuel markets relative to the production potential for ethanol and biodiesel. If both were to be scaled to their maximum it has been estimated that each could supply about 3 billion gallons of fuel per year globally. That is a small fraction of the more than 500 billion gallon global market. On the other hand, it is a huge multiple of current biofuel production. So one perspective to bear in mind is that biofuels represent an enormous investment opportunity but not a game-changing energy input. Another would be that biodiesel enjoy inherent technological advantages over ethanol that will tend to make biodiesel perhaps a more robust investment opportunity than ethanol.