Invest in the biofuels of tomorrow

By Jim Jubak

The Nov. 7 election has been very, very good to ethanol stocks. They've rallied on the theory that a Democratic House and Senate will put more money into alternative fuels than the Republicans in Washington did.

Archer Daniels Midland (ADM, news, msgs), for example, hit a recent bottom on Election Day and then climbed 6.7% in the next week. And the performance of shares of the agricultural-commodities giant is actually at the lower end of an ethanol pack that racked up gains in that week ranging from 6.1% for Aventine Renewable Energy (AVR, news, msgs) to 10.7% for The Andersons (ANDE, news, msgs).

In the short run, I think the financial markets have got it right. The Democrats in Congress are marginally more likely than their Republican counterparts to throw taxpayer money (ethanol producers get a tax credit of 51 cents a gallon from Washington) at the ethanol sector.

In the long run, though, I think the election is irrelevant to the alternative-fuels sector. Indeed, the excitement over the post-election rally in these shares is a distraction from the ongoing transition to the next generation of biofuel technologies.

If you want to understand where this sector is headed in the long run, pay attention to the strategic moves away from corn-based ethanol announced by the new CEO of Archer Daniels Midland and not to the speculation about how much money will go to what technology in the 2007 energy bill.

Short-term energy outlook

Let's take the short term first. The congressional visionaries that drafted the 2005 energy bill had the audacity to mandate the use of ethanol in motor fuels. Starting with 4 billion gallons in 2006, the target gradually climbed to 7.5 billion gallons by 2012.

Thanks to $70-a-barrel oil, however, investment in ethanol production has far outstripped that target. By the fall of 2006, 106 ethanol plants were in production with a combined capacity of 5.1 billion gallons. That's more than the 2006 target. In addition, another 3.5 billion gallons of capacity is now under construction, which doesn't include projects on the drawing boards or those scheduled to break ground soon. Plants currently in operation and already under construction represent 8.6 billion gallons of capacity, more than the 7.5 billion target set by the 2005 law.

State regulations requiring the use of ethanol and growth in market demand from consumers who want to buy U.S. ethanol rather than foreign oil are likely to keep ethanol demand ahead of supply. But there's nothing like a government guarantee to make investors sleep soundly at night. That's why stocks of ethanol producers have climbed with a shift in Congress toward Democrats, who have put a provision to boost the ethanol target by 6 billion gallons -- almost doubling it by 2012 -- into their 2007 version of a national energy bill. Republicans in Congress had proposed an increase only about half as large.

(Don't kid yourself that this has anything to do with the superior virtue of Democrats to Republicans. Farm states just have more clout with the Democratic leadership than they did in a Republican Congress. Iowa is the country's biggest source of ethanol, and Iowa's Democratic senator, Tom Harkin, is in line to head the Senate Committee on Agriculture, Nutrition and Forestry. He would replace Republican Sen. Saxby Chambliss of Georgia.)

A move away from corn-based ethanol

In the long term, however, I'd rather take my cues from a series of speeches delivered by Patricia Woertz, a veteran of Chevron (CVX, news, msgs) who took over the CEO's office at Archer Daniels Midland in May. What Woertz said boils down to this: Archer Daniels Midland, the biggest corn processor in the world and the U.S. market leader in corn-based ethanol production, intends to maintain its global leadership in biofuels by diversifying away from corn.

The company will invest in Brazil, where it will make ethanol out of sugar, in Indonesia, where it will make biodiesel from palm oil, in Europe, where it is already one of the leading producers of biodiesel from rape seed oil -- and, of course, in the United States, where it will expand its production of ethanol from corn.

Forget about all the scientific and not-so-scientific arguments about the fuel efficiency of corn-based ethanol. The "experts" have concluded that producing ethanol from corn either 1) produces 65% more energy than it uses, according to the U.S. Department of Agriculture; or 2) takes 29% more energy to produce than it returns as a fuel, according to David Pimentel of Cornell University.

And forget about out the arguments over whether, once you add back in all the government subsidies, ethanol is cheaper or more expensive than gasoline to produce.

No, what's really driving the strategy at Archer Daniels Midland and at other bigger players in the sector, such as soybean and seed processing giant Bunge (BG, news, msgs), is the rising price of corn and wheat. What worries companies with decades of experience in the volatile commodities markets like these two is the possibility that the competing demand for corn and wheat for human and animal food will painfully squeeze profit margins for ethanol producers.

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