David Jackson The Green Investor

Ethanol has been used for years as the intoxicating ingredient in alcoholic beverages. Equally intoxicating is the recent lure of riches from using ethanol as an additive to gasoline, or even a replacement for it.

Deconstructing a Boom

The ethanol boom began in 2005, after Congress mandated consumption of 7.5 billion gallons of ethanol a year by 2012, more than double the quantity produced in 2004. Investment banks and some investors subsequently threw money at any company with the word "ethanol" in its description.

Despite passage of a bill last year that mandated consumption of 36 billion gallons of biofuel by 2022, investors and bankers soon sobered up as questions about the viability of ethanol surfaced. As a result, many ethanol stocks lost 50 percent or more of their value over the past year.

Fueling Contention

How compelling is the case for ethanol? The subject is practically flammable for a few reasons. Retail investors who "play themes" often become emotionally defensive of a company or technology, and that's certainly happened with ethanol stocks. Meanwhile, there are powerful farming interests behind the promotion of ethanol as a fuel, and opposing vested interests that would lose from increased use of ethanol.

To make matters worse, there's disagreement about almost every factual aspect of ethanol, and opponents easily find studies or research to support their viewpoint. Hopefully, I'll be able to approach the subject objectively, as I'm not invested in any ethanol or farming stocks, or in the stocks of companies that use any competing technology.

Let's look at the facts, then. There are three types of ethanol: ethanol made from corn, ethanol made from sugar, and ethanol made from waste.

Cut the Corn?

Ethanol can be produced from starchy materials, and that includes corn. The starch is extracted from the corn, converted into sucrose, and then fermented. The United States is a leading corn producer, so corn-based ethanol seems an obvious alternative to oil.

But ethanol -- whatever its source -- poses significant challenges. It has less energy content than gasoline. It can't be transported via pipeline because it's insufficiently stable as a liquid. In hot summer weather, ethanol evaporation can be a safety hazard.

For corn-based ethanol, the questions are even more worrying -- in fact, it's not clear that production of corn-based ethanol makes sense at all. Estimates of ethanol's energy yield, namely the energy taken to produce a gallon of ethanol versus the energy provided from the resulting fuel, vary widely.

Some researchers claim that the energy yield is –29 percent, meaning that ethanol production consumes more energy than the resulting fuel produces. Others claim that corn-based ethanol has an energy yield of +33 percent. Either way, a question mark hangs over the fundamental value proposition of corn-based ethanol.

Brazil's Sweet Success

Sugar-based ethanol seems a better bet, not least because of its proven success in Brazil. Brazil leads the way for ethanol use and owes much of its success to its robust sugar cane industry. Brazil's ethanol program has been in place for 30 years, and it now produces 5 billion gallons of ethanol a year; that's projected to rise to 8 billion gallons in the next three years.

Flex cars, which run on ethanol, gasoline, or a blend of the two, account for 22 percent of Brazil's total fleet, and the government wants the percentage to rise to 30 percent. Brazil exports sugar-based ethanol to the United States, Japan, and China.

Ethanol use is widely embraced in Brazil due to a strong national infrastructure for ethanol and the fact that a gallon of hydrous ethanol often costs less than a gallon of gasoline. Ethanol currently sells for about $1.82 a gallon in Brazil, while gasoline there costs about $2.50 a gallon.

Sugar-based ethanol has greater energy efficiency than corn-based ethanol, because sugar cane has a greater concentration of sucrose than corn by about 30 percent. Sucrose is also easier and cheaper to extract from sugar cane than from corn. The result is that the energy yield for sugar-based ethanol is far higher. Research suggests that it yields 8 joules of energy for every 1 joule spent in production, a 700 percent yield.

Still, the United States doesn't import Brazilian ethanol in quantity because of a strict U.S. trade tariff of 54 cents per gallon, promoted by the American sugar lobby in an attempt to exclude competition to high-fructose corn syrup and domestic sugar interests.

Potential Pitfalls

Brazilian sugar-based ethanol is cheaper than gasoline because sugar prices are low at about 11 cents per pound. But increasing demand for sugar-based ethanol may drive up the price of sugar. Money manager Felix Zulauf projects that sugar will increase in price to 20 cents a pound in the near future. That would wipe out sugar-based ethanol's price advantage over gasoline.

Use of corn for ethanol has certainly driven up the price of corn. A chart of corn prices paid by ethanol producer VeraSun shows steep increases. Combine rising corn prices with corn-based ethanol's low or negative energy yield, and the prospects for corn-based ethanol look highly uncertain.

To make matters worse, the environmental case for ethanol and other biofuels is now being questioned. Two studies published by the journal Science found that the adoption of biofuels causes a net increase in greenhouse gas emissions.

The cause is changes in land use. As crops are devoted to ethanol production instead of food, the prices of those agricultural commodities rise, prompting other farmers to convert natural habitats such as rainforests, peat land, and savannahs into farmland. But those natural habitats are critical global carbon sinks, as trees and plants soak up carbon dioxide.

So the conversion of forests to farmland, spurred by rising corn and sugar prices, reduces CO2 absorption and raises the level of greenhouse gases.

The Future of Ethanol?

The land-use problem is avoided by the type of ethanol getting the most press recently, cellulosic ethanol. It's produced from switchgrass, woodchips, corncobs, straw, sawdust, and even municipal waste. In other words, cellulosic ethanol doesn't require crop growth, but uses biowaste and low-value crops that would otherwise be thrown away.

Initial research suggests that ethanol from cellulosic crops has a high net energy yield, producing over five times as much energy as the total used to produce the ethanol. While the research is yet to be confirmed, this net energy yield would blow away even the most aggressive estimates for corn-based ethanol.

Some are estimating that cellulosic ethanol can be produced at a cost of just $1 per gallon, which would be slightly cheaper than sugar-based ethanol, and nearly one-third the cost of corn-based ethanol.

A Canadian company, Logen, is already producing cellulosic ethanol from straw, and GM is pinning its hopes on Coskata, a startup that's devised a commercially viable process to bring cellulosic ethanol to market by 2011 and expects to open a pilot plant by the end of 2008. Coskata's process claims to be able to produce ethanol from almost any carbon-based feedstock such as garbage, plant waste, even old tires. The downside to cellulosic ethanol is that estimated capital costs are much higher than for corn-based ethanol.

The Bottom Line for Investors

Where does all this leave investors? The case for corn-based ethanol looks uncertain. Even President Bush, a supporter of ethanol, seems to have backed off.

Sugar-based ethanol looks more compelling, as long as demand for ethanol doesn't drive up the price of sugar too much. It's no coincidence that the biggest success story for sugar-based ethanol is Brazil, one of the two largest sugar producers. (The other is India.)

And cellulosic ethanol looks economical and attractive. "Waste for energy" -- who wouldn't go for that? The only problem is that nobody has a track record of producing cellulosic ethanol in commercial quantities.

So there are no obvious winners. Like most alternative energies, the jury is out as the technology develops rapidly. In my next column, I'll look in more detail at individual ethanol stocks.