Do Next-Generation Biofuels Pose a Real Threat to Fossil Fuels?

Next-generation biofuels promise a practical way to replace gasoline or diesel without expensive batteries. The reality is that next-generation biofuels have had limited success so far. Still, the danger exists that a price-competitive next- generation biofuel may eventually attack traditional fossil fuels head on.

Pyrolysis
The U.S. Department of Energy recently looked at the current and near-term state of various next-generation biofuels. It found that pyrolysis has the best potential to become truly price competitive with traditional transportation fuels. Its 2012 base case has a minimum cost of $4.55 per gallon of total fuel, close to standard U.S. pump prices.

The real upside could come a couple years down the road. The DOE projects that in 2017 pyrolysis could eventually cost just $2.32 per gallon of total fuel. Now the challenge is in scaling the technology.

Just what is pyrolysis and how real is the threat?
Pyrolysis is the decomposition of organic compounds in the presence of very high temperatures. This means that you can heat up organic matter like grass and break it down into its more fundamental elements to produce biodiesel. KiOR (NASDAQ: KIOR) uses this technology to take common biomatter like switch grass and wood chips, feed it into a facility, and produce fuels like gasoline and diesel.

The reality is that in the short term KiOR poses little threat to the fossil fuel industry. Management has fed investors overly optimistic expectations, and the company has been plagued with production issues. KiOR proudly states that its Columbus facility can produce 13 million gallons per year, but it expects that its 2013 full-year production will only be 920,000 gallons.

KiOR is still a development-stage company so struggles in the ramping-up process are to be expected, but there are other challenges. Management expects to continue posting operating losses at least until 2015, and as of Sept. 30, it had already accumulated losses of $339.7 million. The bottom line is that until KiOR's Columbus facility proves itself, the oil industry has little to worry about.

Algae 
Another attractive idea is to bioengineer algae to produce large amounts of oil. This strategy is nice and simple, but with current estimates it is simply too expensive to compete with traditional fossil fuels. The DOE's baseline estimates project that algae-based biodiesel would need a price of about $20 per gallon to break even. Advances in productivity could help bring the costs down below $10 per gallon, but for the foreseeable future it is simply too expensive.

Solazyme (TVIA) continues to research this technology and is seeing some success with its innovative business model. It understands that it will not be able to compete with fossil fuel markets anytime soon. Instead it is focusing on higher-value oils. Its products have come along nicely, and it has deals with big companies like Unilever and Goulston.  

Solazyme hopes to become cash flow positive by 2015, though it remains to be seen just how successful its ramping process will be. The good news is that it already expects revenue of $40 million to $42 million in 2013. Its third-quarter 2013 balance sheet is attractive, with $194 million in cash, cash equivalents, and marketable securities, and it only posted a net loss of $68 million in the first three quarters of 2013.

Solazyme and its algae are not expected to compete with mass-market fossil fuels for a very long time, but Solazyme's focus on high-margin specialty oils makes it a company worth watching.

Generation 1.0 biofuels
Generation 2.0 biofuels are not expected to kill petroleum anytime soon, but ethanol can be quite profitable. Valero Energy (VLO 0.86%) runs a big ethanol operation, producing an average of 3.6 million gallons of ethanol per day in Q4 2013. The ethanol division managed to produce operating income of $491 million in 2013 thanks to falling corn prices and small ethanol inventories.

Valero's 2013 earnings show that its integrated model is a winner. Ethanol mandates can squeeze refiners' margins, but Valero's big ethanol facilities offset the situation. By playing both sides of the coin, Valero stabilizes its total profit and makes its dividend more secure.

After the price squeeze in renewable identification numbers, or RINs, Marathon Petroleum (MPC 0.70%) decided that it needs more biofuel assets to help protect it from the volatile biofuel markets. With good reason Marathon Petroleum paid $75 million for interests in three ethanol companies. In the first three quarters of 2013, its RIN bill increased to $185 million from $70 million in the same period in 2012.

These latest ethanol facilities should help Marathon Petroleum in 2014, but Valero still has a pricing advantage because it acquired many of its ethanol facilities at rock-bottom bankruptcy prices.

Final thoughts
Should the fossil fuel industry and traditional refiners like Valero and Marathon Petroleum be worrying about second-generation biofuels? Until companies like KiOR can prove that ethanol alternatives like pyrolysis are profitable at a commercial scale, there is little to worry about. If anything, Valero is on the right path with its ethanol division posting $491 million in operating income in 2013.