Ethanol is in Major Trouble Thanks to this Biofuel

Halloween may be a week away, but the ethanol industry is hearing footsteps already. The American Society for Testing and Materials, or ASTM, recently established ASTM D7862, which defines performance requirements and testing methods for a variety of characteristics of butanol-blended fuel. It's a giant step towards the creation of a national butanol industry that will help producers such as BP (BP -0.38%) and DuPont (DD), gasoline blenders such as Valero (VLO -0.80%), pipeline managers such as Kinder Morgan (KMI -0.64%), and drivers like you and me in a number of ways.

What it means for drivers
There are actually three different forms of butanol covered under the new standard that share similar physical properties. I'm going to focus on the commercialization of isobutanol, which I believe has the best potential to make an immediate impact on the nation's fuel supply. Here's how the fuel compares to ethanol:

Source: Gevo White Paper, May 2011

I'll discuss the table in more detail below, but consider that a fuel blend of 10% isobutanol, 90% gasoline would fetch an extra 1,700 miles per 100,000 miles driven compared to a blend of 10% ethanol, or E10. Better yet, isobutanol has established standards compatible with all cars for blends up to 12.5% at the moment -- good enough for 2,200 miles more than E10. Given its limited miscibility with water (low potential to rust engines, pipelines, and storage tanks), there should be potential for even higher blends (16% standards are on the table), assuming the fuel's oxygen content could be improved.

And although ethanol is pretty cheap, isobutanol-blended gasoline could one day be even cheaper for consumers thanks to a number of important advantages. In the meantime, the fuel can actually be added to E10 to increase its performance.

What it means for isobutanol producers
The two biggest names in bio-isobutanol are Gevo and Butamax, a joint venture between BP and DuPont. Each has developed a novel platform capable of producing isobutanol from a variety of sugars using yeast.

Butamax and Gevo are racing to commercialize platforms similar to the one pictured above. Image source: Gevo White Paper

Yeast, sugars, corn -- that should sound familiar. Rather than spend hundreds of millions of dollars building new commercial facilities, each platform can be implemented at existing corn ethanol facilities. Theoretically, the nation's excess ethanol capacity -- about 1 billion gallons per year -- could be converted into 820 million gallons of isobutanol in less than one year of retrofitting. That would represent one heck of a growth spurt and an annual revenue stream worth billions of dollars for BP, DuPont, and Gevo. While end products would likely be focused on high value chemicals rather than fuels at first, ASTM D7862 is an important first step toward the gas tank.

What it means for ethanol producers
Approval of a competing fuel blendstock might sound like bad news for ethanol producers, but it's actually a major blessing. The industry has fallen victim to extreme volatility; posting large profits one year and crushing losses the next. Last year's drought has kept corn prices high this year, but it also created a feedstock shortage that forced several companies to mothball facilities. Ethanol producers will be scrambling once again if and when the EPA decides to scale back its mighty ambitions for ethanol blending requirements.

Enter isobutanol. Not only can the chemical be used in a number of high value products to diversify product portfolios and insulate producers from market volatility, but it also qualifies for higher value subsidies and credits when used as a blendstock compared to ethanol. Better yet, producers can enlist Butamax or Gevo to retrofit their current facilities with virtually no modifications to other parts of their business or supply chains.

What it means for refiners
Valero, the world's largest independent refiner, also stands to benefit from the commercialization of isobutanol. As shown in the table above, isobutanol has a lower RVP than ethanol, which makes it easier and cheaper to blend. Refiners would no longer have to create special base blends of gasoline to achieve an acceptable vapor pressure in the end fuel, leading to savings and reduced emissions of volatile organic compounds. That could be great news for Valero shareholders, especially with ethanol blending costs expected to soar to over $750 million this year for the company.

There's also the possibility that refiners would be able to export butanol-containing gasoline. Currently, many countries place high tariffs on or reject altogether American E10 in an effort to spur their own domestic biofuels programs. Given how quickly the United States could create a butanol industry, European countries, which have already approved butanol blends of up to 15%, would certainly be tempted. Simply put, there would be no shortage of potential customers.

Valero could also ship isobutanol-blended gasoline directly from its refineries through existing pipeline infrastructure -- resulting in additional savings compared to truck or rail delivery. The drop-in fuel would save Kinder Morgan, the first company to transport commercial quantities of ethanol via pipeline, from spending millions building ethanol-specific pipelines and terminals. That would lead to more volume for higher value products in the company's pipeline network, which has historically been the lowest margin segment.

Source: Kinder Morgan, Barclays CEO Energy-Power Conference Presentaion

I don't see low ROI for Kinder Morgan's products pipelines segment as a problem, but there is room for improvement. Isobutanol could offer one possible solution that would benefit investors in terms of savings and improved margins.

Foolish bottom line
Butanol is now clear for takeoff, which firmly establishes a massive market opportunity for isobutanol companies such as DuPont, BP, and Gevo. The fuel can benefit from the same laws and credits that supported ethanol's rise to the top of the blending ladder -- and even qualifies for higher next-generation subsidies in many cases. Further, drop-in capabilities in existing infrastructure throughout the production chain should facilitate a nearly seamless transition into the nation's fuel supply.

There are still hurdles to overcome, however. Neither Butamax nor Gevo has proven that their respective processes are economical or capable of operating at steady-state operations on a commercial scale. I'm confident a company will eventually figure it out. If production can be sustained in large quantities the market should have no problem utilizing the product, especially given its superiority to ethanol. It is unlikely to completely replace ethanol as a blendstock, but having two fuels to choose from will extend many benefits to the industry and consumers.