Small-Cap Ethanol Stocks

Sep 13th, 2007 | By Penny Sleuth Contributor | Category: Macroeconomics

A recent study by Iowa State University says owners of new ethanol plants will see returns evaporate by next year as ethanol prices plunge. I agree. Recently, I took a long driving trip through the Midwest, visiting farms and ethanol plants along the way.

I find it much more useful talking to farmers than just reading government-manipulated statistics. With muddy shoes and a stomach full of homemade rhubarb pie, one thing was abundantly clear: Ethanol from corn is not going to last. I estimate that the ethanol revolution will dwindle by the end of 2008, based on my discussions and observations with various farmers.

The building boom in ethanol plants is likely to go bust by the end of 2007 because of reduced return on investment, increased supplies of ethanol and, ultimately, falling prices. Some analysts estimate that returns will be zero or negative by 2008. On my recent trip, I counted no fewer than five new ethanol plants under construction in Minnesota, which is already home to 16 plants…and that’s just the tip of the iceberg. There are 78 new plants under construction nationwide.

The numbers are staggering. In Minnesota alone in 2007, ethanol production is projected to top 620 million gallons, or about 10% of the overall national production. As the national production number goes beyond 7-8 billion gallons, it’s likely that margins will drop as prices fall. Fourteen billion gallons of production is likely by 2008, and at that point, I think we will see the peak.

In terms of investing in ethanol, whether in shares of a company like Pacific Ethanol (PEIX: NASDAQ) or in corn futures, there are still plenty of profits to be made. In fact, much of the money made in ethanol has been in small caps. The U.S. ethanol industry, with the help of billions of dollars in government subsidies, has brought enormous riches for investors. Just take a look at what this little ethanol producer, Bluefire Ethanol Fuels (BFRE: OTC BB), has been able to do in only its first six months on the market:

Some of the 16 ethanol plants in Minnesota paid for themselves within two years, all made possible because of the 51-cent-a-gallon subsidy. The plants that are already established may be OK, but new plants that have lots of debt are likely to be the first casualties.

Most states now require a 10% blend of ethanol with gasoline, and that’s helped to drive the demand much higher. Now corn growers are lobbying for an even higher percentage requirement, but automakers are reluctant to comply. Sluggish performance and engine damage are the biggest objections of automakers. In some farm communities, E85 ethanol, which is 85% ethanol, is becoming more popular, so some automakers are creating E85 or dual-use vehicles, though it’s far from widespread. E85-rated engines can burn regular gasoline or a gasoline mixture of up to 85% ethanol. Proponents of E85 ethanol vehicles claim sales will top $4.5 million this year.

E85 is seeing significant increases in demand, but still mainly in the Midwest. So for now, it seems a safe bet to ride the wave of demand corn-based ethanol is providing, but keep an eye on the exit. The next interesting market will likely be biofuel made from soybeans or other grains, not corn.

One thing is for certain: As energy prices continue to climb, ethanol production will continue. That means there will be many opportunities for investors and futures traders to benefit from the ethanol boom…while it lasts.

Yours for resource profits,
Kevin Kerr
September 13, 2007

P.S.: This ethanol boom has made a lot of people rich, and it will for a while longer, but when people wake up to the obvious flaws, it’s going to come back and bite these same investors. To protect my Outstanding Investments readers, my co-editor and I have given them seven reports, which I call the New Power Revolution Library.

Penny Sleuth Contributor

The Penny Sleuth also features commentary by other financial analysts, small-cap experts, investment gurus and an array of contributors from various fields and occupations. Their diverse insights and contrarian investing ideas are hand selected by the Penny Sleuth editors.

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