Biofuels are an interesting niche within the energy sector, particularly the controversial gasoline additive ethanol, which tends to grab the most headlines. Ethanol is made directly from corn and is also increasingly derived from things like corn stover (harvest leftovers) and other organic waste materials. The government mandates that this biofuel be added to gasoline, but these mandates envisioned an ever-increasing use of gasoline -- and now the government is backtracking.

Their hearts are in the right place
The idea of ethanol is great; it's made from organic material and, thus, is a renewable fuel. That's a double benefit since ethanol displaces the burning of oil, and growing feedstocks such as corn actually pulls carbon out of the air.

There are numerous problems here even before ethanol hits your engine. For example, using corn to make ethanol means less corn for eating and for feeding animals. Grain giant Archer Daniels Midland (NYSE:ADM) is one of the world's largest players in the ethanol space, with roughly 1.7 billion gallons of annual production capacity. In the second quarter, about half of the $277 million in profit from its corn operations came from such so-called bioproducts.

Source: NEUROtiker, via Wikimedia Commons.

So while the company is happily meeting demand for ethanol here and abroad, half of the corn it handles doesn't get eaten. In a world where roughly one of eight people is undernourished, that's an increasingly tough sell. That's why companies such as DuPont (NYSE:DD) and POET are working on plants that use corn leftovers (stover) instead of corn. DuPont's efforts are intended as a showcase of technology that it hopes to license to others.

Good, but no solution
While using a different feedstock helps with the food issue, it won't do anything to stop the U.S. government from reducing biofuel mandates. That's because the U.S. auto industry is stuck on oil -- or gasoline, as the case may be. Car engines are manufactured to burn gas and up to 10% ethanol. Anything above that level could harm auto engines. To suggest there would be a public outcry if ethanol mandates started to destroy car engines is an understatement.

Like so many other government rules, however, biofuel mandates weren't structured as a relative percentage of actual consumption. They were based on an expectation of ever-higher gas demand. That made sense until gas demand started to fall, a trend that has been in place for the last seven years, according to energy analyst Carmine Rositano of industry watcher GlobalData.

And that has big implications. Rositano recently told FierceEnergy that, "The refining industry has warned that increasing ethanol use in gasoline will exceed the 10 percent mix that dominates car engine designs." In other words, the mandates could destroy your car's engine. That's why the government recently cut the mandates by 15%. There was no choice.

Source: Michael Rivera, via Wikimedia Commons

And with all-electric automobiles from the likes of Tesla (NASDAQ:TSLA) and others, as well as government mandates that cars sip gas instead of gulp it, there's every reason to believe the United States will have to keep lowering its biofuel mandates so the 10% barrier isn't broken. And this is likely to happen as three commercial-scale ethanol projects get ready to come online from, respectively, DuPont, a POET partnership with Royal DSM, and Abengoa (UNKNOWN:ABGB.DL).

What are the implications?
What all this means isn't exactly clear just yet. However, there are a few key takeaways. First, and perhaps most important for your life, the government doesn't appear likely to let biofuel mandates destroy your car's engine. That's great news.

However, from an investing standpoint, domestic ethanol demand needs to be monitored if you own any company with ties to the industry, such as Archer Daniels Midland, DuPont, or Abengoa. It's completely possible that supply will outstrip demand, especially if mandated demand continues to fall. And the U.S. isn't alone in cutting its mandates: The European Union recently reduced its biofuel targets because of concerns over food prices. (If half of your corn goes to biofuel, there's less corn for eating and prices rise.)

Technological advances coming through in the ethanol market are exciting, but market forces and government interventions could materially alter the industry. And government mandates appear to be backfiring right now. Watch both the supply and demand side of the biofuels market closely from here.

Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Tesla Motors. The Motley Fool owns shares of Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.