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In 2005, Congress approved the Energy Policy Act that mandates the use of ethanol in gasoline. The level was 4.7 billion gallons of ethanol for 2007. This will rise to 7.5 billion gallons in 2012. In fact, President Bush was pressing for an extension of this mandate to 35 billion gallons of ethanol by 2017.

At first people thought this was a great idea for something to replace MTBE, or even just substitute in some way for regular gasoline. However, several problems have arisen since then. First, this is an incredibly inefficient way to produce a gasoline substitute. It is estimated that the diesel fuel needed to run the harvesters, the transportation equipment, etc. amounts to approximately one half of the total volume of ethanol produced. These harvesters are also producing smog, so we're not really saving there either. If you then consider that one gallon of ethanol has only about two thirds of the energy content of 1 gallon of gasoline (i.e. your gas mileage will be lower per gallon with more ethanol in the gas mix), the actual benefit of ethanol as an oil substitute is minimal (1 – 1/2 – 2/3 * 1/2 = 1/6). Add to this all of the other costs associated with ethanol production such as labor, etc. and you are really just digging a hole for yourself.

Furthermore, scientists have discovered that ethanol actually led to more smog emissions rather than less (approximately 65% greater than gasoline with MTBE and 45% greater than plain gasoline). The study indicated that the ethanol actually caused a 1-2% increase in the overall smog levels in areas tested in California. This is especially true in hot weather. This is why California has an ethanol waiver for the summer months. Thank you Senator Feinstein. Further, the government is subsidizing ethanol production; and the use of agricultural products (mainly corn in the U.S.) to manufacture ethanol is contributing to the rise in grain prices (food in general).

In sum, the ethanol idea looks like a very bad one. Still, is it likely to be repealed? I have not heard a groundswell that makes me think it will be in the near future. The farmers like it. They make money on the bigger corn crops they produce. Plus, they make more money because the high price of gasoline is driving the partial gasoline substitute price up. This is driving grain prices in general up. This food price increase is causing some people to take a negative notice of ethanol.

The flame caused by this is being doused somewhat by others who are claiming that cellulosic ethanol (made from wood chips, etc.) will be the future answer to all of this. On the contra side, it is unclear that the technology for cellulosic ethanol fully exists at this time. To base an energy strategy on this seems questionable at best. Yet the US may be doing this.

Again will the ethanol mandate be repealed? I don't see it happening in the near future. The trade deficit due to oil importation is so great at the moment that anything which will give even the illusion of lessening this load is not likely to go away in the current market. Plus, the farmers, the fertilizer and seed suppliers, the farm equipment makers, and the ethanol producers/refiners would strenuously object. They would all be hurt by a repeal. Their Congressional representatives would think twice (or more) before repealing this law. In general members of Congress would think twice before doing something that would cause a certain downturn in another sector of the US economy in a recessionary time.

The real problem after all is the oil trade deficit and the high price of oil. Is a repeal likely? No, I don't think so in the short term. It seems more likely that the Congress will let this law ride for the moment. This likely means it will exist until at least 2012. No one ever wants to publicly embarrass themselves by admitting they were wrong. Congressional members (and the President) are no different. Even if Obama is elected, he is from Illinois, which is a farm state. Need I say more?

What does this mean for the markets? It likely means that the Ag stocks, the Ag equipment maker stocks, the ethanol stocks such as ADM will all likely continue to boom. Cramer (not on TV but on a Web site) has been suggesting you buy distant calls on Ag stocks. Then he says you can sell these stocks short on rallies with the safety of knowing you have the calls to insure you against too much upside risk. He is suggesting you do this because an ethanol mandate repeal would be a disaster for Ag (have an immediate negative effect on Ag stock prices).

I have tried to present a non-biased picture of the ethanol situation. To me it looks like ethanol is effectively a waste of time, effort, and money (our taxes are subsidizing ethanol production in the US). Still, there is some promise to the idea of cellulosic ethanol. I can't see a repeal of the ethanol mandate in the near future. The economic consequences for immediate action are too high. A repeal is something that should be well thought out. It should be announced well in advance. Since I have heard very little news of this, I must conclude that it is not imminent.

Rather, I am thinking brokerage houses (perhaps GS and PJ again) are trying to manipulate the markets in Ag stocks. They can make good money if they can move the markets in the direction they are attempting to. They make money as the stocks go down. Then they make money again as the stocks go back up, when driven there by earnings. Many of the Ag stocks currently have high multiples. Many are high growth (POT, MOS, AGU, IPI to name a few), so maybe they deserve these multiples. However, the investment bankers cannot make huge profits on these stocks if they go up more slowly in the future.

But, if there is a big ethanol mandate repeal scare (and relatively recessionary times dictate a little lower food demand), the stocks could get beaten down (more than they have been). The banks could make good money on the way down if they are directing this. Then they could make good money again as the prices are later driven back up as the great future earnings come in.

I don't think the individual investor should allow himself/herself to be manipulated in this way. These stocks have significant upside potential. If you believe these stocks may have significant potential downside risk due to a possible ethanol mandate repeal, don't buy them. However, don't contribute to the investment banks' market game. You are bound to get hurt doing that. They know when they are going to change their minds about recommending (or not recommending) the Ag stocks. You do not. You can be sure that they will take full advantage of this.

On a past earnings and predicted earnings basis, most of the Ag stocks still look great. In fact, the food production area seems likely to be a high growth area for some time to come, regardless of the ethanol situation. Ethanol is merely providing an early boost to the fire. The BRIC et al high growth economies are providing the real fuel for this growth. As they get more prosperous, these countries are demanding more food. They have huge populations. Ag looks like a solid investment for the long term. If you want more clarity on this issue, write to your Congressman or your Senators. They are the only ones who can really give you an accurate estimate of their likely actions.

Stock position: None.

Source: Is the Ethanol Mandate Likely to be Repealed?