The Politics of Ethanol

In a brief meeting at the White House yesterday, President Bush called on Congress to pass his 20/10 plan -- a 20% reduction in gasoline usage over the next 10 years. The plan has two parts: Increase renewable-fuel production to 35 billion gallons annually, and reduce gasoline usage by 8.5 billion gallons annually by 2017. However good the intentions, though, this plan will at best provide questionable relief from dependence on foreign oil. And at worst, it will dish out multibillion-dollar annual subsidies that will hurt the American taxpayer from several angles.

Yet as bearish as I am on the plan, I am also bullish on alternative energy as an investment. Congress will almost certainly pass some kind of legislation in this arena. The bill will almost certainly focus on biofuels -- ethanol and biodiesel -- and several companies will benefit from the billions of dollars in subsidies.

Biofuels are power politics
My theory is that the political support for massive biofuel expansion comes down to securing constituents' votes. Politicians know they can benefit politically from selling the benefits of biofuels in terms of lowering the price at the pump, reducing overall carbon-dioxide emissions, and shrinking our dependence on foreign oil -- and they also know there's too much at stake politically to back away from the issue. What states' politicians stand to benefit the most from backing biofuel? For starters, we can look at the top 10 ethanol-producing states, by volume.

Now, do you notice anything politically significant in this list? What if I told you that the No. 11 ethanol producing state is Michigan? Still stumped?

Here's the deal. In recent elections, the Republicans have established solid majorities in the South and the Mountain states, while the Democrats have secured strong footholds in the Northeast and the West Coast. But in 2004, Iowa, Minnesota, Wisconsin, Ohio, and Michigan were "swing states," defined by a projected margin of victory for either major political party of 3% or less. These five states are at the core of a rapidly disappearing American center composed of 64 electoral votes, which neither party can afford to lose.

I'll go one step further. Michigan, with its heavy dependence on the success of General Motors and Ford, also benefits from biofuel subsidies. Recent increases in fuel-efficiency standards have provided loopholes for so-called flex-fuel vehicles that can run on E85 (85% ethanol blended with 15% gasoline), whether consumers ever use E85 or not -- and Detroit has invested heavily in flex-fuel vehicles rather than in increased fuel efficiency. That probably won't change with the fuel-efficiency standards in the president's new plan. These loopholes, after all, allow GM and Ford to continue their dependence on trucks and SUVs -- two segments where they remain profitable.

What's the upside?
I'm willing to bet that the average American prefers lower gas prices over power politics. Unfortunately, this plan will do nothing to reduce those prices. Yet if the government wanted to reduce the prices, it could easily drop the $0.54-per-gallon tariff on imported ethanol and open the market to less expensive products, such as Brazilian ethanol made from sugar cane.

Instead, even with record gasoline prices, the price of E85 is only about 15% lower than the price of gas. Worse yet, E85 delivers only 75% of the fuel economy of gasoline. For example, the U.S. Department of Energy tested a Dodge Caravan designed to run on E85 and an identical Caravan designed to run on gasoline. In combined city and highway driving, the E85 Caravan achieved 16.4 miles per gallon; the gasoline Caravan achieved 22.5 mpg -- that's 27% lower fuel efficiency for the E85 vehicle. Furthermore, this comparison excludes the $0.51-per-gallon tax credit provided to ethanol producers -- a multibillion-dollar subsidy paid for with your tax dollars.

As for lower carbon-dioxide emissions, ethanol does have benefits. But as the president pointed out, the Supreme Court recently ruled that the EPA should be regulating carbon-dioxide emissions. That regulation would be part of the plan. But I assume, once again, that this ultimately means more biofuels, not lower fuel consumption.

Those hoping that ethanol will reduce our dependence on foreign oil will also be disappointed. The University of Minnesota estimates that even if our entire production of corn were converted to ethanol, it would cover only 12% of our gasoline needs. Absent a huge reduction in transportation-fuel demand, we are going to be depending on the likes of Venezuela, Nigeria, and Saudi Arabia for a long time.

How to make money?
With billions of dollars in subsidies floating around, there have to be opportunities to make big money from this sector. But the problem with the ethanol producers, especially smaller companies, is that ethanol is a commodity, and so one company can't hope to differentiate itself from another. Ethanol plants are sprouting across the Midwest like corn in June, and there is no way any of the small fish will ever achieve the mass of ADM (NYSE:ADM), for example. Profits will be good when gasoline prices are high and corn prices are low, but profits will evaporate when gas prices fall and corn prices rise. Right now, corn prices are on the rise, and a fivefold increase in ethanol production will only drive corn prices higher.

So avoiding the producers, I see two areas where companies will benefit from the ethanol boom. First, Deere (NYSE:DE) has been a big winner over the past year and a half, and I expect that it will continue. A vast expansion of farming requires new combines, and high corn prices allow existing farmers to upgrade their equipment.

Second, ethanol cannot be shipped by pipeline, and the second-cheapest method of transportation is by rail. BNSF Railway (NYSE:BNI), Union Pacific (NYSE:UNP), and many of their peers have seen huge volume growth from ethanol. For more direct exposure, American Railcar Industries (NASDAQ:ARII) and Trinity Industries (NYSE:TRN) manufacture the tank cars needed to transport ethanol.

Foolish final thoughts
I tend to agree with Charlie Munger when he recently said running cars on fuel derived from corn "is about the dumbest idea I've ever seen." Beyond being just dumb, it is also expensive, with subsidies estimated to cost taxpayers between $6.3 billion and $8.7 billion annually. Plus, high corn prices affect nearly the entire food supply, from corn sweeteners in soft drinks to the feed for chickens and cows. In short, we are going to pay for ethanol both at the pump and at the supermarket.

But no matter how much the investing geniuses and I agree on the economics, I think the political tailwind behind ethanol is unstoppable. Still, even with the tailwind, investors need to pay attention to value in this area. With the ethanol hype bubbling over, most of the companies mentioned here are priced for excellent performance. For the time being, I'm hanging on the sidelines, running the numbers, and waiting for lower prices.

For more biofuel-related Foolishness:

• Earth Biofuels' Kiss of Death
• Fueling the Debate: Ethanol vs. Biodiesel
• ADM Is a Bio-Player

Check out what other Foolish investors think of biofuel companies such as Earth Biofuels and ADM in the Motley Fool CAPS online community.

Fool contributor Robert Aronen does not own shares of any of the companies mentioned. The Fool's disclosure policy is way more fuel-efficient than either of those Dodge Caravans.