Ethanol investors better sniff for bubbles


Whether ethanol will play a modest role in cutting U.S. dependence on foreign energy over the long term is still open to debate. Whether ethanol companies are a good place to put your money is not.

The industry has blown a nice little bubble for itself. Anybody suggesting you buy ethanol stocks either isn't paying attention or has been taste-testing the product.

With ethanol plants cropping up from New Jersey to California and ethanol companies stumbling over each other to sell stock, we have all the elements of a good idea gone giddy.

Pacific Ethanol, based in Fresno, Calif., saw its stock go from $6 last year to $42 in May. Insiders are bailing out of the stock. The chief operating officer, who sold $30 million worth of stock, resigned recently "just to get some perspective on life," according to what he told The Fresno Bee, despite the fact that the company's California plant hasn't opened.

VeraSun Energy, the country's second-biggest ethanol maker, based in Brookings, S.D., raised $420 million in an initial public stock offering two weeks ago. ($420 million is equal to nearly half the general-fund budget for the state of South Dakota.) The money will build more distilleries for ethanol - corn alcohol used as gasoline additive or substitute.

Similar expansion by VeraSun competitors "may result in excess production capacity in our industry," reads the part of the lengthy "risk factors" section in VeraSun's prospectus.

No kidding.

Last week, Aventine Renewable Energy, based in Pekin, Ill., raised a reported $390 million in an initial offering to finance its own ethanol-making capacity. Next up is Hawkeye Renewables, based in Iowa Falls, Iowa, which filed for an initial offering a month ago.

Andersons, a Toledo, Ohio-based grain distributor with an ethanol sideline, saw its stock zoom from $12 (split-adjusted) last year to $60 a couple of months ago. On Friday, the company announced a secondary stock offering that would raise about $85 million to build the ethanol business and let insiders run for the exits to the tune of another $12 million.

The biggest ethanol producer of all, Archer Daniels Midland, is diving in even deeper. The food company just hired Patricia Woertz, a longtime Chevron executive, as its chief executive officer, signaling a shift to the energy business. Last month, at an industry conference, Woertz promised to make "robust" investments in ethanol, according to the Chicago Tribune.

And we haven't even mentioned ethanol partnerships and private corporations making the same kind of bets. At the beginning of 2005, the country had 81 ethanol plants, according to the Renewable Fuels Association, the ethanol trade group. Now there are 97, with 33 more under construction.

A certain amount of ethanol investment is needed.

As a gas additive ethanol replaces the noxious methyl tertiary butyl ether, which replaced the even more noxious lead. Many states have banned MTBE, and even where it's not banned lawsuit-leery refiners have switched anyway, driving up ethanol demand and the need for supply.

Additional ethanol investment can be rationalized, based on Congress' command in last year's energy bill that the country burn 7.5 billion gallons of "renewable" fuel by 2012.

Current ethanol production capacity is 4.5 billion gallons a year; add plants under construction and you get 6.4 billion gallons a year, says the Renewable Fuels Association. But nothing can justify the prices that investors are paying for ethanol stocks. They're already expensive based on profits, and those profits will prove temporary.

Like oil refiners, ethanol distillers make money on the spread between the cost of raw material and the price of the finished product.

Profits have been fat this year thanks to "historically low" corn prices, according to the VeraSun prospectus, as well as robust marginal ethanol demand as refiners ditch MTBE.

Neither of those conditions is likely to hold up. Corn prices have been rising, thanks in part to demand from ethanol makers. At the same time, new refining capacity will force vendors to cut prices to get business.

Sure, the 6.4 billion gallons of capacity marked by the trade group is only partway toward the 7.5 billion-gallon congressional requirement. But that doesn't take effect for six years. (The mandate for 2008 is 5.4 billion gallons.) And other ethanol plants are on the drawing board.

There are other risks.

Most cars can't use the "E-85" mostly-ethanol blend, which limits demand.

Ethanol makers burn lots of natural gas. (Which belies the idea that ethanol is "renewable" energy. The energy burned to make it is not renewable.) Soaring natural gas prices can wreck profit margins. Falling oil prices could also hurt, because ethanol would become less attractive as a petroleum substitute.

So could removal of ethanol's lucrative federal subsidy, which Energy Secretary Samuel W. Bodman said last month "needs to be thought about" if prices stay high. Somebody will make money on ethanol, but it won't be many public shareholders. For the nation and for investors, much of this investment would be better made in oil refineries. Or nuclear plants.

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