FSU: "Growing Fuel" by Elliott H. Gue 08/31/2006

When it comes to electricity, there are several possible fuel sources. Power plants can be run on natural gas, coal or even nuclear power derived from uranium fission. But transportation fuel is another matter entirely. When it comes to powering cars, trucks and trains, crude oil is king.

The truth is that for the foreseeable future, oil will remain the world's key transportation fuel. While fuel cells and other fuels of the future may generate their share of hype, none will be commercially viable for years. But just because we can't replace crude doesn't mean we can't profit from alternative energy sources that are potential partial replacements for crude. Even if alternatives continue to capture only a small part of the giant global market for transportation energy, the investment implications are enormous.

One fuel type that is gaining traction in parts of the world as a partial crude oil replacement is biofuel. The term biofuel describes a number of different fuels and alcohols that can be produced from organic matter. In most cases, the organic matter used is some sort of agricultural product such as corn or sugarcane.

The two most common types of biofuel right now are ethanol, an alcohol derived through fermentation, and biodiesel, a form of diesel produced from vegetable oils like canola (rapeseed) oil.

One obvious factor supporting biofuels is that they're a renewable resource. Crops can be replanted each year. Unlike crude oil, biofuels aren't a diminishing resource. Furthermore, a variety of crops can be used as the basis for biofuels including some such as switch grass--a prairie grass--that have heretofore been seen as waste crops with little food value. Such crops can be grown almost anywhere in the world. Biofuels can reduce dependence on the Middle East, albeit by a small amount.

Biofuels are also environmentally friendly and significantly reduce emissions of sulphur oxides, nitrous oxides and even carbon dioxide as compared to traditional petroleum-based fuels.

Current Use

Ethanol, an alcohol that can be derived from a variety of agricultural products, is probably the biofuel that's best known globally. Brazil has gone the furthest in promoting and popularizing ethanol; the South American country has actively promoted and subsidized ethanol production for more than 20 years as a response to the 1970s oil crises.

In recent years, as gasoline and diesel fuel prices have been on the rise, ethanol has become an extraordinarily popular fuel in Brazil. Production topped 13 billion liters (roughly 3.25 billion gallons) there in 2005, nearly half the total global production of ethanol for the year. Brazil is also a major exporter of ethanol to the US, Japan and the European Union.

Brazilian ethanol is produced almost exclusively from sugarcane. Sugar is a highly efficient crop for producing ethanol for a number of reasons. The yield from sugarcane is higher than for some other agricultural commodities such as corn, and Brazil enjoys a favorable climate for producing sugar. Thanks to the long growing season Brazilian farmers can grow more crops on an acre of land than their US counterparts. And the labor involved in farming is much less expensive in Brazil.

Raw sugarcane is grown primarily in two regions of Brazil, the northeast and the south central. Due to a favorable climate, both regions can be replanted twice per year (two crops annually) in both regions. Based on 2003 prices, and figures produced by the US Dept of Agriculture, Brazil's South Central region sported some of the lowest costs for raw sugar production in the world, 5.5 cents per pound, compared to closer to 8 to 10 cents per pound in the US.

Thanks to these factors, Brazil is the world's low-cost ethanol producer, selling ethanol for approximately $25 per barrel, around a third of the cost of a barrel of crude oil as of this writing.

Most modern cars can tolerate ethanol mixed with conventional gasoline or diesel fuel. Typically, conventional cars can handle mixes as high as 20 to 25 percent ethanol. In the US, for example, ethanol is regularly used as a gasoline additive for cars in mixes of approximately 10 percent.

In Brazil, the most popular cars today are known as flex-fuel vehicles. These cars are capable of burning any mixture of conventional derived fuel and ethanol--and can run on 100 percent biofuel. Surging energy costs made flex-fuel cars the most popular cars sold in Brazil in 2005; according to the Brazilian government nearly 54 percent of the cars sold in the nation last year were capable of handling flex-fuels.

This amazing popularity is having some profound ramifications for the global sugar market. Brazil, already the world's largest producer and exporter of sugar by a wide margin, diverts about half its total crop to ethanol production. In prior years, Brazil was able to export significant quantities of ethanol abroad; in 2005, however, due to extreme domestic demand, the country was forced to scale back exports.

And Roberto Rodriguez, the country's agricultural minister, stated earlier this year that due to rapidly rising demand for the flex-fuel, Brazil will need to spend $10 billion during the next six years to build out 73 new ethanol producing mills and convert another 2.5 million hectares of land to sugar cane production. This would constitute about a 50 percent increase in production.

Not surprisingly, sugar prices have rocketed higher over the past three years. This move has been due in no small part to concerns that a larger chunk of the world’s sugar production will be diverted to ethanol production and away from other, more traditional uses. And demand for sugar as a food additive is increasing drastically worldwide for one simple reason: rapid economic development in Asia. Simply put, as countries become wealthier, consumers tend to consume more sweets and fats per capita. Rising ethanol use coupled with rising demand for sugar as a food substance is driving sugar prices higher.

Brazil isn't the only country that uses ethanol. The US produces ethanol from corn--it's typically used as a fuel additive. In certain parts of the country, however, a version of ethanol fuel, E85, is available. A total of roughly 600 stations in the US dispense E85, most located in the Midwest. This fuel is comprised of 85 percent ethanol and 15 percent traditional gasoline.

To run E85, vehicles must be flex-fuel capable. Such vehicles are certainly becoming more common all over the US. In 2006, Ford and General Motors plan to produce a combined 650,000 flex-fuel vehicles, including ethanol-ready versions of popular models such as the Ford F-150 pickup and the Chevy Tahoe truck.

According to the Dept of Energy, E85 vehicles are less fuel efficient than their conventional counterparts, getting roughly 25 percent fewer miles per gallon. This raises average annual operating costs slightly. However, emissions of greenhouse gas (carbon dioxide) are reduced by roughly 25 percent using the flex-fuel vehicles.

US ethanol is largely produced from corn and it's far less economically attractive than ethanol produced from Brazilian sugar. Corn yields much less ethanol per a given unit of weight and the growing season is shorter for the vast majority of the country due to climate. Producing ethanol from corn costs roughly twice as much as it does in Brazil, and the industry has remained reliant on government subsidies for some time.

But ethanol use in the US will continue to grow because it's the only viable blending agent for reformulated fuel in the US right now.

The Clean Air Act established regulations governing the emissions of pollutants such as carbon monoxide (CO) into the atmosphere. As gasoline burns the carbon in the gasoline bonds with oxygen in the air, producing both CO and carbon dioxide (CO2). Increased levels of carbon monoxide occur when gasoline isn't fully combusted in the engine.

Heavy traffic congestion and slow speeds tend to increase the levels of CO released by cars; heavy levels of CO emissions are associated with smog and can lead to health problems. As a result of the Clean Air Act and these environmental issues, many urban areas require regular testing of an automobile's emissions to ensure compliance with CO standards.

A big part of this is what's known as reformulated fuel, fuel that's designed to reduce emissions of CO and other problematic byproducts of incomplete combustion. At any rate, blending agents are used to make reformulated fuel by oxygenating gasoline; adding oxygen-containing chemicals to fuel promotes more complete combustion and lowers the amount of poisonous CO released into the air.

The second purpose of most fuel blending agents is to boost octane content. Most consumers are familiar with those small yellow stickers posted on the front of gasoline pumps at your local petrol station. Those numbers represent a measure of the fuel's octane rating.

Without delving into the science of octane with too much detail, suffice it to say that the higher the number, the more controlled the burn of the gasoline. Thus, higher octane ratings are desirable and improve an automobile's performance. Most important, without a blending agent, most gasoline wouldn’t meet octane ratings necessary to run modern cars.

For many years, the most popular blending agent for fuel was a chemical known as methyl tertiary butyl ether (MTBE). The beauty of MTBE is that it’s both an excellent oxygenator and a great octane booster. MTBE is also a relatively cheap additive, so it doesn't affect the cost of gasoline at the pump a great deal.

But MTBE has its own set of problems. Specifically, MTBE bonds with water readily. When the chemical leaks out of fuel tanks, it pollutes the groundwater and is thought to cause cancer. Roughly 28 states have banned or severely limited the use of MTBE at this time. As a result, the use of MTBE was phased out nationwide earlier this year.

In addition, federal law somewhat protected companies from legal liability with respect to MTBE due to the oxygen mandate in gasoline, but that protection expired in May. No company is willing to take on that legal risk.

With MTBE no longer an alternative, refiners needed another blending agent to perform the same tasks. The only real alternative is ethanol, an alcohol made in the US mainly by distilling corn. Ethanol isn’t as effective a blending agent as MTBE, but it can fill the same basic role. And almost all cars on the road today can tolerate ethanol mix in gasoline as high as 15 percent. Moreover, the government has mandated a renewable fuel standard that would nearly double the country's ethanol and biofuel use by 2012.

Beyond Ethanol

Ethanol isn't the only biofuel at use in the world today. Some crops can be distilled into vegetable oils and used to produce an organic form of diesel fuel dubbed biodiesel. Like ethanol, biodiesel is easier on the environment and is a renewable resource.

The EU has been particularly aggressive in promoting the production of biodiesel, with Germany and France being the two largest producers. The EU has set a target to derive 5.75 percent of transportation energy from biofuels (a combination of ethanol and biodiesel).

Already, considerable progress has been made toward ramping up capacity.

It's clear that the EU has already been rapidly ramping up their capacity and output of biodiesel (see the chart below) In Germany, for example, more than half of all cars run on diesel and can tolerate a mix of 20 to 25 percent biodiesel with conventional diesel. In France, closer to 65 percent of all cars operate on diesel, making France another attractive market for biodiesel. In addition, there are tax breaks for many individual EU member states to encourage the further use of biodiesel.

Note: 1 metric tonne = 2,204 pounds; 2006 estimates based on production capacity.

Source: European Biodiesel Board

Roughly 80 percent of all biodiesel produced in the EU comes from rapeseed, an oilseed that is used to make canola oil, a popular edible oil the world over. Just as Brazilian ethanol use is pushing demand for sugarcane, biodiesel demand in the EU is currently consuming roughly a third of the total EU rapeseed crop. With production slated to rise sharply in coming years, you can imagine the effects on rapeseed demand: Production of rapeseed and crushing plant capacity (to covert rapeseed to oil) will need to ramp up considerably if the EU is to come close to meeting its goal of biodiesel production.

Outside the EU, the other crop that's gaining traction in biodiesel production is soybeans. Like rapeseed, soybeans can be easily converted to oil. Right now, demand for biodiesel is only a small part of the picture for beans but that could certainly change in coming years.

There are very few direct plays on the biofuels business. In recent months, several ethanol producers have listed on the US exchanges--none are worth owning at current valuations. However, there are other ways to play biofuels.

The biofuels boom spells a global expansion in agriculture. To keep up with growing demand for corn-derived ethanol and increase exports to meet rapidly growing Asian demand, the US will need to see a rapid expansion in corn production. As mentioned above, Brazil is a true breadbasket for the rest of the world; it will also see growth in agricultural activity and, most likely, ethanol exports.

The scope for Europe to actually boost farm output is limited by high costs and limited arable land. That said, European biodiesel demand will drive increased oils production across Europe and pull imports of soybeans from the US, Brazil and other prime crop growers.

The best plays on biofuels longer term are companies that sell into the agriculture markets--companies producing key inputs like seeds, fertilizer and pesticides. Alternatively, the big agribusiness companies that process crops and handle storage will also benefit from all the increased demand.

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