Government Involvement in Energy Investments: What's the Risk?

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Includes: AVR, ECA, PEIX, VSUNQ
by: Rick Konrad, CFA

It is interesting to see how badly politicians can screw up supply-demand imbalances. As a Canadian who endured Canada's National Energy Policy of the early 1980's, it worries me to see the proposed royalty changes that the Alberta government panel has recommended. Our American friends who endured last year's Hallowe'en surprise are swearing to me (both in an affirmation sense as well as a profane sense) that they have had it with Canadian energy policy. It''s not just individual investors who are incensed.

On Friday, the EnCana Corporation, (NYSE:ECA) the Calgary-based natural gas and oil sands producer was quoted as saying that if the panel's recommendations for draconian increases in royalties are implemented:

EnCana plans to cut its 2008 capital investment in Alberta by about C$1 billion, or 30% to 40% of the C$2.5 billion to C$3 billion the company has planned for Alberta-based activity.

Furthermore, it would re-allocate capital to investments outside Alberta.

Investors should remind themselves that the proposed royalty changes at this stage are recommendations with no certitude that they will be implemented.

It is very strange to see a province that has enjoyed such wealth creation in this energy cycle, and that has attracted capital largely because of a political culture that has favored capitalism finds itself seemingly breaking from that tradition.

My libertarian leanings are not directed just at my fellow Canadians. Witness the political interference that has created the mess in the ethanol markets in the U.S.

The long anticipated ethanol oversupply has arrived, and will continue to put downward pressure on ethanol margins and crush spreads. The politics of bio-fuel triggered very strong emotions last year, for example,

Perfect cannot be the enemy of the good. Corn ethanol is not perfect, but it is the best alternative. Our realistic options in the next decade are limited to oil or ethanol. Do we want to feed our farmers or Middle East terrorists?

The Sunday edition of The New York Times featured an article on the sudden surplus of ethanol. As the article highlighted:

But companies and farm cooperatives have built so many distilleries so quickly that the ethanol market is suddenly plagued by a glut, in part because the means to distribute it has not kept pace. The average national ethanol price on the spot market has plunged 30 percent since May, with the decline escalating sharply in the last few weeks.

Commodity based industries have no moat. You are as good as your worst competitor, and price becomes the only differentiator. At the 2006 Berkshire Hathaway (NYSE:BRK.A) annual meeting, Charlie Munger made some negative comments about the economics of ethanol, in his imitable fashion right in front of Bill Gates, his fellow Berkshire director who some months earlier had just announced an $84 million investment in Pacific Ethanol (NASDAQ:PEIX). Charlie also made the following statement:

Running cars on corn is about the stupidest thing I ever heard of. Our government is under tremendous political pressure [to keep pushing and supporting corn ethanol] even though it makes no sense. More energy is used producing ethanol than it creates and that's without considering the damage to the topsoil producing fuel when we could be producing food.
Munger further stated that,
It's silly to drive up the price of food in order to provide an uneconomic fuel, as well as a dumb government policy.

Believe me, I am a great supporter of going green, and I believe the long-term returns may well be substantial. But, getting there through ethanol is going to be a little ugly over the near term.

In a Goldman Sachs (NYSE:GS) report that was released earlier last week by its biofuel research team, estimates were reduced to reflect the new realities of ethanol. Aventine's (AVR) target price was cut to $11 from $17. There are $24 target estimates out there. Pacific Ethanol (PEIX) was trimmed to $9 from $11. The high target here is $17.60. Finally, VeraSun (VSE) was trimmed to $10 from $11 by Goldman, and there is a $24 estimate out there.

I am an investor, not a "player" of commodities. I'm not being arrogant, I am merely avoiding an area where I have zero competency. The scatter in target prices, estimates and growth rates suggests that there will be an opportunity here, I can't decide whether its on the long or short side.

Goldman suggests that margins need to fall to incentivize a slowdown in future capacity growth, and that utilization levels of 80% versus the current full utilization are need to bring ethanol into balance. Of course, 80% utilization spells weak margins in ethanol economics.

Here is a look at the GS charts on supply/demand as well as crush spreads for ethanol: Ethanol Supply and Demand

It appears that according to GS, there is a 200 million gallon per month surplus of supply, roughly 40% of current capacity.

Ethanol prices are now trading at over a $0.40 per gallon discount to gasoline, the other side of the $0.50 premium that it traded for most of this decade. Based on a little bit of rusty physical chemistry, it should trade at a discount...there is less BTU value. As the GS report points out, and Charlie reasoned two years ago, there is no reason that the markets should not be rational about BTU content in the pricing of ethanol.

Here is a GS chart on the Ethanol spread: Ethanol Spread to Gasoline has weakened considerably

The report argues that the new target prices suggested are based on replacement costs, what it costs to build a plant. Reasonable enough, but ultimately the value of any plant depends on the economics of the plant, not what it may cost to build it. If cash flows are poor, there is a high likelihood that the value is impaired, at least the sunk cost.

The National Energy Policy of Canada was introduced in 1980 to increase both Canadian control and Canadian ownership of the energy industry. It also sought to protect all Canadians from surging oil prices. The federal government would accomplish their goals through measures such as price controls and federal taxes on oil and gas production. These measures would increase federal government control in the oil and gas industry.

Similarly, since 1978, the United States government has granted a multitude of tax incentives and subsidies to promote the growth of a domestic ethanol industry. Taxpayers' repeated payments in the form of subsidies to corn growers, ethanol producers, and opportunity cost serve no other purpose than to artificially prop up the corn and ethanol industry.

Allowing government to choose winners and losers instead of the market has impeded investment in other alternative fuels which may make much more economic and even environmental sense. Equally stupid in my view, is the large handouts that go to conventional energy companies, another seemingly endless cycle.

From an investment standpoint, it still leaves me wondering about energy investments in North America, is government involvement here worth the investment risk?

Disclaimer: I, my family, or clients have a current position in Berkshire Hathaway. I, my family, and clients do not have a current position in any of the other securities mentioned.