Not too long ago, our ethanol industry was laughable at best. Today, we may be too good at producing the blendstock. Source: USDA/Wikimedia Commons.  

The United States is the world's leading ethanol producer, accounting for nearly 62% of world production. It holds down the top spot by sporting 211 ethanol production facilities with a combined nameplate capacity of 14.6 billion gallons per year. Eight more facilities are under construction, which will add an additional 620 million gallons of production when completed, pushing America's ethanol capacity to over 15 billion gallons per year. While that seems to paint a picture of growth in the industry, consider that most new facilities utilize next-generation feedstocks and technology platforms -- making them drastically different in terms of value. Another depressing statistic: The U.S. has roughly 1.26 billion gallons of idle capacity.

There is a long laundry list of reasons for idling facilities. The drought that ravaged corn stockpiles in 2012 cleared out many inefficient operators and sent production costs skyward, forcing even the most efficient producers to cut back. Although feedstock prices have dropped recently, uncertainty surrounding the Renewable Fuel Standard and the fact that fuel blenders have hit the Blend Wall point to storm clouds on the horizon. Worse yet, as gasoline consumption falls with an increasingly efficient automobile fleet (and fuel economy set to nearly double by 2022), the amount of ethanol needed for a national 10% blend rate falls, too. Simply put, the U.S. has way too much ethanol capacity for present and future needs.

The only way for producers to make it out alive is through innovation. Leading companies such as POET, Abengoa, and DSM may lie outside of the reach of investors, but you can use their example when looking for investment opportunities. How are producers such as Valero (NYSE:VLO) and Green Plains Renewable Energy (NASDAQ:GPRE) turning the industry's capacity glut into an opportunity?

Forget transportation woes
Why in the world would one of the country's largest traditional refiners want to produce ethanol? The battle between ethanol producers and Big Oil companies alone makes that paradoxical. Account for the jabs at the biofuel's low margins by Valero management on quarterly conference calls and the head scratching could require medical attention. But if you look deeper, you'll see the brilliance.

Valero Renewables is the proud owner of 10 state-of-the-art ethanol plants with a combined production capacity of 1.2 billion gallons per year. "State of the art" means the facilities efficiently monetize waste streams and attain optimal yields of 2.8 gallons per bushel of corn (Valero produces 2.84 gallons per bushel across its fleet). In addition to efficient production, Valero is able to leverage its extensive logistics and transportation network -- built for its refining and retail business -- when selling the 3.3 million gallons of ethanol it produces each day. Since ethanol cannot be transported in traditional pipelines, transportation is expensive and requires a bit more logistics than products such as gasoline would.

Valero will move mountains (or highways) to improve its logistics network. That's good news for ethanol. Source: Benicia Refinery project description. 

While not all of the ethanol produced by Valero is blended into its gasoline products, the ethanol business allows the company to capture value upstream (production) and downstream (blending). Will other large refiners soon climb the list of the largest and most efficient ethanol producers? They certainly have the critical advantage of world-class transportation and logistics networks, which each of the largest ethanol producers in the country boasts. But perhaps more innovation will be needed to make ethanol production profitable in tough market conditions.

Recycling carbon with algae
Green Plains Renewable Energy is the continent's fourth-largest ethanol producer with roughly 1 billion gallons of production capacity. It also produces 250 million pounds of non-edible corn oil each year and owns 822 million gallons of annual blending capacity. You can bet it has a world-class transportation and logistics network, but its biggest competitive advantage may be a novel technology platform being developed by BioProcess Algae. The ethanol leader owns approximately 60% of the developmental algae company, up from just 35% in early 2011.

This facility covers five acres of land, but could soon be expanded to 400 acres. Source: BioProcess Algae YouTube video.

What makes the technology so disruptive? The modular platform is designed to convert the ultimate waste stream, carbon dioxide, into algae biomass for animal feed, nutraceuticals, fish feed, chemicals, and fuel. It's a pretty simple idea. Carbon enters the ethanol production process as sugar from corn and leaves in the form of ethanol (sold), distillers' grains (sold), corn oil (sold), and carbon dioxide (discharged into the environment). Ethanol facilities pay for the carbon that escapes into the atmosphere, so why should they just throw money away? Producing high-value products from carbon dioxide emissions would greatly enhance the margins of ethanol production and distribute risk across multiple, unrelated markets.

If the phase 3 facility above is successful, then the decision will be made to expand the facility to a larger commercial operation. Better yet, if economical, the modular platform could be licensed to any manufacturing facility that emits carbon. Given the massive opportunity, I firmly believe that carbon dioxide will be monetized for all manufacturing facilities in the future -- but we'll have to see if Green Plains Renewable Energy will be a player in the new industry.

Foolish bottom line
How bad is America's ethanol glut and overcapacity? Imagine taking Valero's entire 1.2 billion gallons of production off the market, which accounted for over 12% of the company's income in 2013 despite representing less than 2% of its total assets. The problem will only get worse as the country's gasoline consumption declines and requires less ethanol to reach 10% blend rates. Smaller, less-efficient producers will be forced out of the market, while larger producers will be forced to become ever more efficient and innovative. Luckily, Valero and Green Plains Renewable Energy appear to be on the right track.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.