Wall Street History

---

Wall Street History

02/10/2006

Ethanol, Part I

“History” might be in the title of this column, but of course I’ve
used it to address issues in the financial world that are drawing
intense interest today. Such is the case with “renewables” and
“biofuels.”

Following are the figures for the energy mix in the United States
(12 months ending October 2005), courtesy of Cambridge
Energy Research Associates, the Energy Information
Administration and the Wall Street Journal.

Petroleum – 40%
Natural Gas – 23
Coal – 23
Nuclear – 8
Renewables – 6

Breaking down the renewables category:

Hydropower – 2.8%
Solid biomass – 2.4
Geothermal – 0.4
Biofuels – 0.3
Wind – 0.1
Solar – 0.1

[Comes out to 6.1% due to rounding]

As you saw the other week, President Bush focused on
renewables in his State of the Union address. Many skeptics are
saying that we’ve heard this song before; that when oil prices
inevitably decline, and the price at the pump heads back below
$2.00, we’ll just resume our old habits and the incentives to
change them will fade away.

Personally, I disagree. I firmly believe we have turned a corner,
though with everything else that has a long timeframe we may
not recognize the big changes taking place for a while.

I’ll continue to address many of the specifics, particularly on the
geopolitical front, in my “Week in Review” column. But for
now I want to start with a discussion on biofuels, specifically
ethanol, E85 for 85% ethanol-based fuel.

A long simmering debate that has been lying in the background
is now on the front pages, owing to issues as diverse as farm
subsidies and the cost of sugar, the auto industry, the availability
of fuel pumps, and the very sources of energy today.

To start things off, I present a good primer on the ethanol topic
from Ken Root.

Many of you know I’m a product of New Jersey and not exactly
an expert on farming. But a number of years ago I made the
acquaintance of a delightful family that calls the Oklahoma
Panhandle home and I’ve done a little to keep abreast of the
issues as their own farm fortunes have grown.

One way to do so has been to subscribe to the High Plains
Journal, where Mr. Root writes a terrific weekly column for the
publication. He is also farm anchor at WHO Radio in Des
Moines, Iowa. Ken has been gracious in allowing me to reprint a
piece he did for HPJ this past month.

---

Ken Root

“Ethanol’s big chance”

Although most of America still thinks ethanol is best served as
E3.2 (beer), the potential for E85 (fuel) may be at its highest in
2006. That’s because a convergence of ethanol suppliers,
facilitators, promoters and users could align this year and
government subsidies could ignite real world use. There are
also detractors, enhancers and unknowns, but here’s how I see
the future of high-powered ethanol as automotive fuel in the
years ahead.

Suppliers

The U.S. Congress passed an energy bill in 2005 that will offer
incentives for production while mandating use of a growing
quantity to top out at 7.5 billion gallons per year in 2012.
Although total U.S. capacity is far short of this annual number,
ethanol refineries are being constructed at a rapid rate that will
achieve the capacity far ahead of the mandated use date.

Promoters

Farm state support of ethanol knows no bounds within legislative
bodies and farm/agribusiness organizations. This promotion is
only slowed by differences between those who wish to mandate
its use and those who wish to provide financial incentives to
encourage consumption. The Republican leadership of the Iowa
legislature is poised to put through bills that will compensate
fueling stations for the cost of an E85 compatible storage and
pumping system to the tune of $30,000 in tax credits per
installation. Estimating the total cost to be $60,000 to $80,000
and adding in federal incentives, the incentives add up to
$55,000. Iowa proposes funding 200 new pumps per year for
nine years.

Facilitators

Ford and Chevrolet are both building E85 compatible engines
and offering them in popular vehicles. Bill Ford could be
mistaken for Grandpa Henry in his promotion of ethanol in his
cars and trucks. Other automobile manufacturers can’t be
outdone by a competitor, so look for some ethanol compatible
engines at every dealership. Saab has an engine that super-
performs on E85. Indianapolis will feature the fuel at the Indy
500 race in May.

Users

The foreign oil-sensitive public is the most likely to purchase an
E85 compatible vehicle once they see that there are enough
pumps nearby to utilize the American-grown biofuel. The overall
public, especially in the major population centers, is still a little
uncertain about ethanol in general and E85 in particular, but not
as adverse as early users who still hate the stuff that clogged their
carburetors. Promotion by government and car companies, with
the addition of clearly marked E85 pumps and highway signage,
will offer an attractive alternative.

Detractors

The petroleum refiners and retailers still own the gasoline market
and their interests are best served by selling their own product. It
will be very hard to get major oil companies to install an E85
fueling station under their main canopy or to give it equal
promotion with their gasoline grades, even though they may all
be spiked with an ethanol blend to raise the octane level.
Petroleum retailers are fighting hard to keep ethanol use from
being mandated on a state level while pumping everyone for
money before they install pumps.

Enhancements

Ethanol plants, in effect, add refining capacity in this country as
the fuel only has to be blended with gasoline at a 10- or 85-
percent level. This reduces the amount of refined gasoline that
has to be imported. Grudgingly, the first new U.S. oil refinery in
30 years is now being built in Arizona. Site selection and
construction of petroleum refineries will continue to be an
environmental battle.

High gasoline prices will drive alternative fuel use as much as
any incentive. E85 has to remain more economical than
unleaded in cost per mile to increase use. U.S. presence in the
Middle East should keep OPEC nations in control of oil supply
and that should keep gasoline above $60 per barrel.

Promotion and awareness of the desirability and availability of
bio-fuels has to continue. Trade names and branded products
will stick in the public mind better than numbers and generic
words.

Unknowns

Profitability of ethanol refineries is still undetermined. Changing
technology could make older plants less efficient than others and
radical shifts could change the preferred feedstock. Brazil may
be able to export ethanol to the U.S. more cheaply than we can
produce it. Cuba might become an ethanol producer in the post-
Castro era. We are going to have to be hypocritical to keep
Central American production out while endorsing CAFTA.

Many investors, including farmers, who own shares in ethanol
refineries and other groups are holding meetings and distributing
their prospectuses. Some may not have management or a
business model that will generate a return for shareholders.

Finally, ethanol is about to go mainstream. It’s total impact on
U.S. oil usage may be small, but it will be the first step away
from petroleum since we fell in love with the automobile a
hundred years ago.

---

We’ll pick up the discussion next week.

Brian Trumbore

---