The companies that will make the big bucks in the ethanol business will be the ones that succeed in three innovations…more on that in a minute.

First, in case you didn’t know, ethanol — which is made from the sugar of corn or sugarcane — is basically grain alcohol that can be mixed in varying amounts into gasoline.  Despite what some of its critics think, ethanol will emerge as the alternative fuel of choice in the U.S. In fact, the government has already picked ethanol to move to the head of the alternative energy fuel class.

The U.S. Energy Policy Act of 2005 requires that ethanol production increase to 7.5 billion gallons a year by 2012. Right now, production is at 4 billion gallons annually. And with demand for ethanol outstripping supply at this point, the future for ethanol producers looks bright. However, arguments over the viability of the fuel remain.

E-85, a blend of 85% ethanol and 15% gasoline, is more expensive than traditional gasoline and can only be used in flex-fuel vehicles. A price of $2.75 a gallon was quoted to me this morning (it’s probably cheaper in the Midwest where they have easy access). Where ethanol is used as an additive (a 10% blend is common and can be used in any vehicle), the cost per gallon is about the same you would pay for a gallon of traditional gas.

The cost to actually make and transport the ethanol is where it gets hairy. I’ve seen literally hundreds of scenarios, some saying that it costs the equivalent of 3 barrels of ethanol to make just one barrel of the fuel. 

But ethanol proponents have made the argument that there are more costs associated with gasoline production than with ethanol. Some ethanol freaks will argue the “true cost” of a gallon of gas… one telling MSNBC.com it would be more accurate to assume prices to be around $5 a gallon (that is, if you choose to include things like the money it takes to support the military forces that are protecting our overseas oil supplies).

And location is also creating problems in the ethanol world. Ethanol’s main ingredient – corn — is plentiful in the rural Midwest, but not so much in the populated coastal areas of the country.  

Think about it this way: the population of North Dakota is about 640,000 people, whereas the population of the Washington D.C. area (including the Maryland and Virginia ‘burbs) is almost 6 million. So an ethanol plant in North Dakota’s corn country would have to be able to get its product to the relatively cor0.n-free capital.

This feat would be simple if the ethanol-gasoline mixture could be piped straight from the refinery to the populated East Coast like pure gasoline. But an ethanol-gasoline mixture can’t be piped, because the two ingredients separate, which could cause the fuel to damage a car’s engine. Ethanol has to be transported on the road, a much more costly endeavor than sending it through a pipe.

More on that from MSNBC:

“‘Corn is in the center of the country and gasoline consumers are on the coasts,’ he [Dr. Darren Hudson, a professor of agricultural economics at Mississippi State University] said. ‘So transportation costs can be quite high — roughly double the cost of shipping gasoline’ or about $1.20 per gallon of ethanol.”

Then there’s the ongoing problem with “reformulated gasoline” — required in some areas that have strict clean air standards. There is a cheaper additive, called MBTE, which has been widely used, and even required in some states (Maryland used MTBE for years). But as it turned out, gas companies found that MTBE had the ability to creep through underground gas tanks into the groundwater. Some have tried to link MTBE with cancer, especially in rural areas where residents rely on well water. So much for cleaner air…

And the EPA has already recommended that MTBE be phased out nationally… and a buyout is in the works which will pay oil companies and refiners some $1.75 billion to phase out production — further cementing ethanol’s fate as MTBE’s replacement.

MSNBC reports that reformulated gasoline is required in nine major metropolitan areas with the worst ozone air pollution problems and in other areas that have voluntarily chosen to use the fuel — this will be a huge market.

Small ethanol companies can eventually solve these problems by developing cheaper and more transportable blends of ethanol fuels, and investors who recognize their achievements early will reap the rewards. Here’s what to look for:

1. The most obvious of the three: Look for a company that can make ethanol cheaper than the 3 to 1 ratio mentioned earlier through a new or improved process. This could include using a mix of products, like ethanol from corn along with a  bioethanol made from various waste products. There will always be a cost argument associated with ethanol, but the main argument for its implementation is to reduce dependence on foreign oil. So making the fuel on the cheap is an added bonus — and one that will naturally the ethanol producers the most customers.
2. Solving the transportation dilemma should be right up some small-cap chemical company’s alley. Finding an economic way to transport an ethanol-gasoline mixture through a pipeline will be a huge breakthrough — whether through a special chemical additive or an improved blending/manufacturing process. This would naturally solve the price argument as well by eliminating a majority of the transportation costs. If you find a company that can do this, you’ve found a winner.
3. Create a cleaner-burning ethanol blend. A company needs to come along that can silence the critics and cement ethanol as the only option for MTBE replacement. Ethanol reduces a lot of emissions, but Dr. Hudson noted that if it does not burn properly, burning the fuel can increase nitrous oxides. Again, this is something that could be within reach for a small-cap chemical or ethanol company over the next few years.

There’s no question that the ethanol market is growing leaps and bounds. And as with any new trend in business, the ones that innovate and stay ahead of the game are the ones that see success year after year.

I’ll keep an eye on ethanol for you and report back soon.

Until next time,

Gunner

Small-Caps Could Solve the Ethanol Dilemma was originally featured in the Penny Sleuth.