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The United States is the largest producer of ethanol in the world, manufacturing over 14.8 billion gallons in 2015. Unfortunately, only 13.7 billion gallons was blended into the nation's gasoline fuel supply thanks to the "blend wall," which limits ethanol blends to 10% of gasoline consumption. This problem is a driving force behind efforts at engineered biology conglomerate Intrexon (NYSE:XON) to develop a better alternative to ethanol. The goal is to feed methane found in natural gas to engineered microbes that will produce isobutanol, which has more energy than ethanol, can be blended with gasoline well beyond 10%, and can be transported in existing gasoline infrastructure.

If the company succeeds in up-front R&D, it will tap natural gas leader Dominion Resources (NYSE:D) to help commercialize the natural-gas-to-fuels platform. While isobutanol represents an important project in Intrexon's R&D pipeline, there are several categories of obstacles that need to be overcome -- and opportunities to be exploited -- before investors reap the potential rewards.

Regulatory hurdles

The regulatory environment for butanol fuels, including isobutanol, is quite a mess at the moment. There is an ASTM (American Society for Testing and Materials) standard for biobutanol that allows blends of up to 12.5% with gasoline, although a waiver exists that allows up to 16% when it is replacing 10% ethanol blends. However, refiners with over $50 million in annual sales are currently not allowed to sell butanol-blended fuels for road transportation due to a provision in the Clean Air Act. This can be overcome if isobutanol is registered under the correct Code of Federal Regulations (40 CFR Part 79). Got all that?

It gets messier still. Assuming the above occurs, there isn't an incentive for refiners to blend isobutanol into gasoline. That's because there is no approved manufacturing pathway for isobutanol under the Renewable Fuel Standard (RFS), which means manufacturers don't have access to valuable federal tax credits in place for other first- and second-generation renewable fuels. This is important for Intrexon investors, considering the company would be the beneficiary of any tax credits, which is where most of the profits are made for renewable fuel manufacturers. Laws instituting incentives in 2005 (RFS 1) and 2008 (RFS 2) have been absolutely critical in nurturing the American ethanol industry into a global superpower.

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Image source: Compiled by author with data from EIA.gov.

Not complicated enough? Consider that there's still a question of whether Intrexon's natural-gas-to-isobutanol will even be considered a renewable fuel. Although it will be manufactured by living organisms, the ultimate feedstock (what the U.S. Environmental Protection Agency ultimately cares about) for commercial production facilities will be a fossil fuel. If the company were instead utilizing methane in industrial flue gas or from landfills, then its isobutanol would qualify as a renewable fuel. However, production volumes would be significantly lower due to limited availability, so focusing on fossil fuel feedstocks is wise from a commercial perspective.

Regulatory opportunities

Ideally, Intrexon and Dominion Resources will push to have their isobutanol considered a renewable fuel under RFS, which will be critical for incentivizing use of the blendstock over ethanol. Despite it being sourced from fossil fuels, there may be a way to work out a compromise by exploiting the EPA's desires to move away from first-generation renewable feedstocks that depend on food sources and toward next-generation cellulosic feedstocks that use inedible waste biomass. Natural gas certainly isn't edible, so the EPA may be willing to create a special waiver, however unlikely.

It may also be possible for Intrexon and Dominion Resources to team up with refiners tired of subsidizing renewable ethanol and pressure the EPA to allow a special waiver for a better fuel blendstock, such as isobutanol, although that's a battle investors might rather avoid.

A better way forward might seek to exploit another desire of the EPA: to encourage the use of fuels that do not list gasoline as the dominant ingredient. While the technology exists to power cars with fuel blends of 85% ethanol and 15% gasoline, or E85, the market has shown little interest. This is due to several compounding factors, including consumer lack of interest stemming from ethanol's poor energy density -- resulting in much lower fuel economy compared to gasoline -- and a lack of infrastructure investment into special fuel pumps required to handle high ethanol content. Not so for the next-generation blendstock. Fuels containing 85% isobutanol, or Bu85, may be more appealing to consumers worried about giving up fuel economy compared to gasoline and could conceivably be distributed from existing fuel pumps at your local gas station.

However, the carbon footprint of Intrexon's platform -- which temporarily sequesters carbon from natural gas into fuel, only to release it again as carbon dioxide when the fuel is combusted -- may ultimately make it difficult for the EPA to consider slapping "renewable" in front of the fuel's name. In the end, failure to make the company's isobutanol eligible for federal credits would severely limit both the adoption of the fuel and the economics of commercial production and sales.

What does it mean for investors?

Intrexon and Dominion Resources have a vast opportunity in front of them if they can commercialize their isobutanol manufacturing platform and make money doing so, but there are significant regulatory hurdles standing in the way. These can be overcome -- and it may be possible to exploit certain regulatory opportunities -- but investors should be aware of the complexity and difficulty in moving a product from laboratory R&D to the real world. As it turns out, significant technical hurdles remain that could stop Intrexon from ever realizing its goal. I'll cover those hurdles in a future article.

Maxx Chatsko has no position in any stocks mentioned. Follow him on Twitter to keep up with developments in the engineered biology field.

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