Could This Summer’s Drought Ruin Ethanol Companies?

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When the Department of Energy crafted its policies on ethanol, I'm guessing it wasn't anticipating the events that have unfolded in the past six months. With corn prices rising and gasoline prices stagnant, ethanol producing companies' profits are getting squeezed from both sides – and companies like BioFuel Energy (Nasdaq: BIOF  ) might not be able to survive it.

I'm just a bill, sittin' here on Capitol Hill
The Energy Independence and Security Act of 2007 was an ambitious plan to move the U.S. away from fossil fuel dependence. The bill called for the U.S. to increase production of biofuel, which most of us know as ethanol, to 36-billion gallons by 2022. Digging deeper into the legislation, we see that it specifically calls for a target of 15-billion gallons of ethanol from corn. To help companies meet this goal, the U.S. government has offered several tax credits to incentivize the production and consumption of ethanol. 

At that time, when much of the American populous were fretting about peak oil and corn prices had only gone up 54% since World War I, the idea of using an undervalued U.S. commodity to lower prices at the pump seemed like a good and well-intended plan. More importantly, it looked like a great business opportunity. Companies from the oil and gas side, the agricultural side, and even a slew of new business popped up, hoping to take a big chunk of this industry.

Fast-forward to today. New drilling technology has unlocked vast quantities of oil and natural gas right here in North America, and we might have more than we could possibly imagine. Also, this summer's drought has put a premium on corn, and its price has almost doubled since the inception of the regulation.

Putting the pieces together, the environment for ethanol producers stinks. On its recent earnings release, BioFuel Energy reported that its revenue from ethanol was less than the costs for corn and production. When events like this happen, it is almost impossible for a company to survive.

What a Fool believes
Just like it was difficult to predict this series of events, it is hard to tell if or when this trend will reverse. More than likely, oil and gas production in North America will continue and will help to at least stabilize fossil fuel prices. On the other end of that spectrum, only a great weatherman will be able to predict if we will continue to have drought-stricken summers. This is just another bit of bad news for a sector Charlie Munger once coined "quite possibly the stupidest thing ever invented by rational people."

Even without the aforementioned problems, there are several other flaws in the ethanol production business. It relies on seasonal crops that require several inputs, such as fertilizer and pesticides, and can only be harvested a couple of times a year. Dynamics like these bring the whole industry's sustainability into question. Since the financial crash of 2008, two of what were some of the largest players in the space – Pacific Ethanol and VeraSun Energy – have both filed for bankruptcy, and several of the smaller players have followed suit.

Looking at Biofuel Energy specifically, it has positioned itself rather poorly to deal with these types of situations. Unlike some of the other big players in the space, Biofuels deals exclusively in the production and sale of ethanol. Companies like Archer Daniels Midland (NYSE: ADM  ) are diversified on the agricultural end of the spectrum and can rely on their other agriculture products. On the other end of the spectrum, Valero Energy (NYSE: VLO  ) can fall back on more traditional oil and gas operations. Archer Daniels and Valero derive just 14% and 3% of their revenues from ethanol, respectively.

Investors who think that there is a big future in synthetic fuels should look to companies like Solazyme (Nasdaq: SZYM  ) and Amyris (Nasdaq: AMRS  ) , who both have developed methods for modifying algae and bacteria to convert nutrients into petroleum products. With inputs of sunlight and generic sources of carbon, nitrogen, and phosphate, these companies do not need to worry about volatile commodity prices. Both Solazyme and Amyris have also gone to great efforts to diversify their offerings, so they won't get caught with their pants down when oil and gas prices fall again.

There are several ways to play the energy markets, so the challenge is to determine the most lucrative and sustainable companies for your portfolio. Our analysts at the Motley Fool keep a keen eye out in this space and have identified "The Only Energy Stock You'll Ever Need." We have made a special report outlying this unique opportunity within the oil and gas space. For your own free copy, click here.

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