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     Aug 1, 2006

Beware of the ethanol hype
By Salman Anwar

Ethanol appears to be the new and exciting source of renewable energy, drawing considerable investor interest, as reflected by recent initial public stock offerings such as VeraSun Energy and Pacific Ethanol. The use of ethanol is also politically expedient, as it is perceived to be an alternative to Middle Eastern oil.

Ethanol also benefits from growing concerns over the long-term supply of oil. And in the US, ethanol's environmentally friendly role is growing because of legislation mandating a phasing-out of other fuel sources with the toxic ingredient methyl tertiary-butyl ether (MTBE) in favor of ethanol.

Yet there remain big questions about the projected long-term

viability of ethanol as the major oil-replacement fuel stock.

Why ethanol?
The economics behind ethanol do not necessarily demonstrate its practicality. Simply stated, it is unclear whether ethanol will be the solution to US energy woes.

At the same time, there is currently an inadequate supply of ethanol to fulfill demand. The pressure from government forced the United States to produce 4 billion gallons (15.14 billion liters) of ethanol in 2006, which is forecast to increase to 7.5 billion gallons (28.39 billion liters) in 2012. This is helping to fuel an ethanol boom that will double the size of the industry by 2008. A number of states have a mandate in place to use 10% ethanol as the blending agent, replacing MTBE, which contributes to more environmental pollution than ethanol. As of April at least 85% of Hawaii's gasoline must be 10% ethanol.

In the United States, ethanol has been used in vehicle fuel for many years, but only as a blending agent. The recent increase in oil prices and angst over depleting oil reserves has led everyone's attention toward ethanol production. Over time it is likely that ethanol will become much more important as a fuel source, but the technologies to make that happen appear to be decades away. It took decades for petroleum to be the main source of energy and years to make it burn more efficiently. For example, petroleum was first used as medicine, then as a fuel for lighting, then slowly moved toward its use in transportation.

It took time for petroleum to go mainstream. The same factors apply to ethanol; it will take years before ethanol can fully replace oil, because basically everything runs on gasoline. For example, the median age of light vehicles in the US vehicle fleet is about 14 years, and it could take about 14 years for the fleet to be replaced by vehicles that can run on both gasoline and ethanol.

Who's pushing ethanol?
There is an important political dimension to the use of ethanol in the United States. The farm lobby is strong and promotes ethanol as the fuel of the future, especially as it represents considerable profit potential. According to the Organization for Economic Cooperation and Development (OECD), it would require almost a one-third of US farmland to power one in 10 of America's cars with home-grown ethanol based on corn (maize).

Consequently, the government is investing in a technology that is not up to the challenge because of land-use issues, a weakness in transportation and refining infrastructure, and a very political regime pertaining to keeping potential external sources of ethanol fuel-stock out of the market. According to an editorial in the Jamestown, New York, Post-Journal: "It should come as no surprise that ethanol's best friends are in farm states - including members of Congress who represent them. Regardless of whether expanded use of ethanol would be good for US motorists, it would help those states."

The study conducted by Alexander Farrell of the University of California, Berkeley, published in Science magazine indicated that corn-based ethanol cuts overall greenhouse-gas emissions by only 13% compared with gasoline. In Brussels, the European Commission has found that the standard production methods for sugar-beet ethanol in Europe reduced global-warming emissions by one-third. Consequently, the question must be raised as to why Americans are investing so many resources in corn-based ethanol that reduces emissions by only 13%, when it can invest the same resources toward producing sugar-beet-based ethanol that reduces the emissions by 20% more. The answer, of course, is that it is all about keeping the farmers happy and showing the American public that the country is striving toward independence from foreign oil imports.

Who benefits?
Analysts are predicting that by 2008, ethanol production will reach 8 billion gallons (30.28 billion liters) in the US, but there remains a worry that the demand for corn could strain food supplies, raise costs in the livestock industry, and ultimately lead to a land rush. Already Agriculture Department economists expect the value of this year's corn crop to climb roughly 20% over last year, also elevating the prices of sugar to record levels. The agriculture industry will benefit the most. This includes such companies as Archer Daniels Midland, Cargill Inc, Monsanto and DuPont that are involved in the production of ethanol or corn seed, or genetically engineering them to provide the most acreage.

There is no disagreement that the ethanol frenzy will lead to a clean, green alternative to oil and relieve the US from the dependence on the Organization of Petroleum Exporting Countries for oil, but many believe it makes more economic sense to import this fuel from Brazil or any other country that produces ethanol more cheaply or is much better placed in the production method of ethanol. The US therefore would benefit from being less stringent about its policy on ethanol imports, otherwise it will waste its scarce resources on the production of a fuel that is not made efficiently at an optimal cost. This would require the US to work side by side and to welcome the transfer of technology from countries that have a competitive advantage in ethanol production. Scrutiny by Congress is needed to research more about the expanded use ethanol before a policy is made to encourage it as the mainstream fuel.

Obstacles faced by ethanol
The most significant non-political obstacle the ethanol industry faces in the US is a lack of infrastructure. Unlike oil and natural gas, ethanol or gasoline containing ethanol cannot be transported by pipeline. The current oil refineries cannot be used for ethanol and will need to be converted. The only viable ways of transporting this fuel are either through trucks or over water. This is because ethanol is soluble in water and thus can be easily diluted or contaminated. To develop the infrastructure that supports ethanol will require time as well as the investment of resources.

Most US ethanol plants are in the Midwestern states, and that poses another challenge. Transporting ethanol to the energy-hungry east and west coasts is a daunting task. One helpful factor is that the majority of the existing and proposed ethanol plants are on or a near a major waterway, but that poses another challenge, the need to equip all the ethanol plants so they can transport the fuel via water, for example trucks needed to bring the fuel from the site to the vessel. This is capital- and time-intensive. Another mode of transport for ethanol is via railroad, but this will require special cars. In addition, ethanol would have to compete for limited rail transport space with coal.

Another obstacle is that owners of E85 (85% ethanol and 15% gasoline) flex-fuel vehicles are unlikely to use E85 if it costs more than gasoline. For people to replace cars, especially when they are higher in price, poses a barrier for the consumer. The only thing that might persuade people to buy flex-fuel vehicles is if it has a significant cost advantage in the long run or if it is government-subsidized.

Ethanol economics
Currently, US ethanol production cannot meet demand, and imported ethanol is required to balance supply and demand. For the imports to be economically feasible, ethanol prices must be above $2.45 a gallon (65 cents a liter). That is because if the value of imported ethanol is 46 cents a liter, with custom duty and transportation costs of 4 cents a liter it is viable subject to the above-quoted price. Currently, ethanol makers can break even with oil priced at $55 a barrel. In the beginning ethanol production will be expensive because the technology needs to be further researched and developed. In the years to come, there are chances for this technology to take off, but at a cost.

For all the challenges facing the US ethanol industry, efforts are being made to meet rising demand. Over the next 12 months, at least 39 new ethanol plants are expected to be completed. The new plants will add 5.3 billion liters a year to the current 17.4 billion. This will put the United States ahead of Brazil. But there remains the very basic problem of not having enough cars available that use ethanol. Ford, DaimlerChrysler and General Motors have flex-fuel vehicle programs under way, and the lineup of new cars is expected to be unveiled by the end of the year.

A look at Brazil
Similar to the United States, the Brazilian government subsidized the production of ethanol back in the 1970s. There was also a lot of investment from the private sector into the ethanol industry, sufficient to make Brazil independent from foreign oil. Brazil is the world leader in flex-fuel cars, and President Luiz Inacio Lula da Silva has embraced the concept of being independent for energy. Brazil has perfected this technology of flex-fuel vehicles to the point that for a Brazilian the cheapest fuel choice is clearly ethanol.

That is because Brazil produces ethanol efficiently and cost-effectively. Brazilian ethanol is sugarcane-based, unlike the corn-based version in the US, which requires more time and money. The Brazilian auto fleet is composed of 20% flex-fuel vehicles, and Brazil is the second-largest producer of ethanol. The country has taken to heart an approach of a vehicle that can run on multiple fuels. It has advanced in that aspect to an extent that it hopes to export flex-fuel cars and technology around the world. The idea for non-gasoline-powered vehicles goes back to the 1970s fuel crises in Brazil, when its economy nosedived. Brazilians enjoy the fruit of that initiative in the form of energy independence and cheap fuel.

Benefits of ethanol questioned
Many experts question the benefits of ethanol in the US. Domestic plants run on petroleum, leaving ethanol's net contribution to reducing the use of oil questionable. David Pimental, a top agricultural expert from Cornell University, has calculated that powering the average US automobile for one year on ethanol (blended with gasoline) derived from corn would require 4.5 hectares of farmland, the same space needed to grow a year's supply of food for seven people.

Adding up the energy costs of corn production and its conversion into ethanol, 34,610 British thermal units are needed to make one liter of ethanol. One liter of ethanol has an energy value of only 20,340Btu. Thus 70% more energy is required to produce ethanol than the energy that actually is in it. Every time you make one liter of ethanol, there is a net energy loss of 14,270Btu. Consequently, there is a loss of energy for using ethanol as an alternative fuel source. Moreover, that does not include the trucks and the tankers involved with transport, which require petroleum as well. Despite the structural challenges facing ethanol, there remains a certain momentum to push this fuel as the alternative fuel to oil.

One should not be carried away with the sudden excitement in the ethanol industry. The investment bankers first fueled the dotcom boom with the technology hype, and then that bubble burst. Now it appears to be the time for ethanol. What needs to be brought to an investors attention is that it is difficult to see how ethanol can go mainstream as a fuel if 70% more energy is required to produce ethanol than the energy that actually is in it.

Constant recommendations to buy the stock of ethanol companies and all the hype that is going into ethanol appear to be temporary because global oil prices have forced the world to seek alternative energy sources. The candidates for alternative energy such as butanol, hydrogen, wind, and biomass are also under constant research-and-development focus. Butanol, which is produced from sugar beet, is more environmentally friendly and cheaper than ethanol. Will butanol, hydrogen, wind, and biomass be able take over ethanol's pace?

An intelligent investor will not go with the market hype and will be mindful about the threats that ethanol faces from the other sources of energy and varying crop yield controlled by the weather. At the same time it is clear ethanol is one of the options now under development within the alternative-energy sector, and it needs to be monitored to determine its potential impact on efforts to expand beyond global reliance on petrochemical products.

(Posted with permission from KWR International, Inc, a consulting firm specializing in the delivery of research, communications and advisory services.)


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