Outlook for a New Generation of Biofuels

Includes: ADM, ANDE, CZZ, EWZ, GU, VLO
by: Cabot

By Brendan Coffey

Investing in biofuels stocks isn’t a slam-dunk. Ethanol-related stocks got a huge boost in early 2008 after the EISA was passed, but by the middle of that year, criticisms of the effect of ethanol on the price of food supplies reached a crescendo, and the market turmoil added to the pressure on biofuels producers. Some that had been seen as good bets, like #2 ethanol producer VeraSun, went under and saw its assets sold off at a fraction of their value to refiners like Valero (NYSE:VLO).

Yet lately, we’re seeing increasing strength in the shares of the surviving ethanol-related companies. Commodity broker Archer Daniels Midland (NYSE:ADM) has used the weakness to build up its position as an ethanol refiner, building its own plants and buying up other capacity. It’s now the largest producer in the country, and is in a position of strength if gasoline prices surge and demand for ethanol materializes. Similarly, second-tier ethanol players that survived the worst of it, like The Andersons (NASDAQ:ANDE), are seeing good relative performance lately, too.

But in this environment, I’m not sold on investing in any domestic ethanol producer just yet. There are a few reasons for that. Let me talk about the macro ones I believe could drive long-term movement in ethanol.

One is the global economic uncertainty: The debt troubles of Greece, Spain and other countries in Europe have increased the risk of the common euro currency taking a beating. And if investors flee the euro, that almost certainly means the dollar will strengthen. And when the dollar strengthens, there is a strong inclination of oil prices to fall. That’s because oil is priced globally in dollars, meaning OPEC can ease its pricing to placate its best customer (us) while still going home with as much money in their own currency as always. (It’s no coincidence that 10 years ago 99-cent gas coincided with the unrivaled strength of the U.S. dollar.) If oil prices drop, ethanol is a lot less attractive to refiners, retailers and ultimately us drivers.

Another reason I’m not convinced about domestic ethanol just yet is the concern that using up edible crops (or at least arable land to grow inedible, ethanol-producing corn) will spark another wave of outrage if food prices spike again domestically. And that is a significant possibility if the dollar doesn’t strengthen and the U.S. middle class continues to get squeezed from all directions.

Food supply shocks like that are also why China mandates that no biofuels in its country be derived from edible crops. The leading biodiesel maker there, Gushan Environmental (NYSE:GU), collects waste cooking oil for restaurants for its product and eventually will make fuel from a non-edible pistachio plant that grows well on land otherwise unsuited for farming. (We had some success investing in GU at the Cabot Green Investor a couple of years back, but low global diesel prices and tariff issues in China make the stock one to be wary of right now.)

Lastly, perhaps the primary reason I’m wary of domestic ethanol stocks is that I expect Brazil will be the most effective ethanol producer. For one, Brazil is the dominant grower of sugarcane in the world, producing about one-third of all cane.

Ethanol can be made from sugarcane, and in fact cane is a superior raw material for ethanol, since more of it converts into energy, and does so more easily. By one measure, sugarcane ethanol returns eight times the energy used to produce it, while corn ethanol returns just 1.3 times the energy used to make it. Now add in the fact Brazil not only exports a lot of sugar, but also makes a lot of ethanol too.

In 2009, Brazil is estimated to have produced 28 billion gallons of ethanol. Most of that was used domestically, accounting for half of Brazilian automobile fuel. But exporting it to markets that offer a greater return, like the United States directly, or through intermediary countries that sidestep trade barriers, is hardly unrealistic. And if you project an export market for American ethanol, consider that it is China and Brazil which have just inked a deal to start sending Brazilian ethanol east.

In this environment, I’m putting the odds favoring a company called Cosan (NYSE:CZZ), the largest sugar producer in Brazil and also the biggest ethanol producer. The company just signed a deal with Royal Dutch Shell (NYSE:RDS.A) for co-generation and marketing of each other’s fuels in a bid to lay the groundwork for a global ethanol giant.

CZZ has more than doubled in the past year, jumping from 4 to nearly 9, giving it a market cap of $2.8 billion, and it has held up well in the recent market retracement.

Cosan should also benefit from strong prices in the world market for raw sugar this year too (Brazil sells its crop into the world market this summer). I don’t think it’s time to buy it just yet, and commodity-based stocks can be very volatile, but if you’re interested in profiting from biofuels, keep your gaze to the south.