This month, purely for the purpose of research, I have been immersing myself in alcohol.
To be more precise, I have been learning all about ethanol, which is in fact ethyl alcohol, a 22-proof grain alcohol. And in the prize fight between alternative forms of energy, ethanol is a major contender.
I wanted to find out if there’s a real opportunity here for you and me to make money. But my alcohol soaked research says otherwise. And there’s a popular little ethanol stock trading on AIM that I’d advise you to avoid, too.
A bluffer’s guide to the ethanol market
Last year the 95 ethanol refineries spread across the United States produced four billion gallons of the stuff, almost double the amount in 2001, and more than 20 times production levels in 1980. This took the US to the top of the table of world ethanol producers, level with Brazil. China, in third place, produced one billion gallons last year out of a global total of 12 billion gallons. The UK produced 92m gallons.
This booming production represents a revival for the ethanol industry, which was first used as fuel in America in 1908. The famous Model T Ford could be modified to run on either gasoline or pure alcohol, and in the 1920s Standard Oil was marketing gasoline with a25% ethanol content in Baltimore.
With the advent of cheap oil, however, the ethanol industry died out. But its long history means that, unlike new forms of “alternative energy” such as fuel cells, the basic production process is tried and tested.
Ethanol is produced by fermenting starches and sugars such as those found in grain and other crops. The majority is made from corn. The fermented starch is then distilled into alcohol, leaving a by-product called “distillers grain” which is used as a nutritious animal feed.
There are two types of motor fuel that use ethanol. E10 is a blend of 10% ethanol and 90% gasoline. Since the 1980s all carmakers have covered the use of E10 under their warranties, and no engine modifications are required to use it. E85, on the other hand, is a blend of 85% ethanol and 15% gasoline. This does require a “flexible fuel” engine, and there are now about four million of these on the road in the US, particularly in government-mandated vehicles such as urban transit buses.
E85 is less efficient than gasoline. It takes about 1.5 gallons of ethanol to deliver the same mileage as 1 gallon of gasoline, but for E10 the difference in efficiency is a negligible 1.5%.
Cleaner than the alternatives...and growing fast
Ethanol is gaining popularity because it is perceived as a green fuel. The addition of ethanol increases the oxygen level in gasoline, so that the gasoline burns more completely and fewer carbon monoxide particles and other harmful exhaust emissions are released into the atmosphere.
It received a boost in 1990 when the US Congress passed amendments to the Clean Air Act, making the use of oxygenated fuels in specific regions of the United States mandatory during the winter months. The Reformulated Gasoline programme followed in 1995. It required the sale of reformulated gasoline in nine major urban areas to reduce pollution.
Along with adding ethanol, the most common method of oxygenating – or reformulating – gasoline is by blending it with methyl tertiary butyl ether (MTBE). Ethanol has a higher oxygen content, but MTBE has so far enjoyed higher demand thanks to its lower cost. However, traces of MTBE have been found contaminating the water supply in parts of the US, so it is being progressively phased out. That clears the way for more widespread use of ethanol.
In short, the ethanol industry is in a phase of rapid growth. At the end of 2005 a further 29 new US refineries were under construction. Along with extensions to nine existing sites, they will add about 50% to the industry’s production capacity. Most of these refineries are in the “corn belt” states to the south-west of the Great Lakes.
How corn and petrol prices drive ethanol profits
The production of ethanol from corn is a mature technology, so it’s unlikely to see significant reductions in production costs. Its profitability therefore depends mainly on the cost of corn, which can fluctuate widely. Plus, of course, there’s volatility in the sale price of ethanol. As a substitute for petrol, it moves in line with the retail price of US gasoline.
One company now trying to cash in on the ethanol craze is GTL Resources (AIM:GTL). Trading at just 2.2p per share, at first sight this may look like a bargain.
However, there are no fewer that 2.27 billion of these shares out there, so although the price is low the value of the company on the stock exchange is £50m.
In fact, that’s £50m riding on GTL’s ethanol plant in Illinois which, after 16 months of construction and a total outlay of $80m, will start production in December. GTL owns 85% of the venture, with the remainder largely in the hands of the local farmers who supply the corn feedstock.
With the price of ethanol around $2 per gallon, well above the $1.40 assumed within the plant’s original budget, GTL’s share price has been moving up in anticipation, providing some welcome relief to shareholders who have seen it sink from 65p back in 2000.
Fill ‘er up with sawdust, straw and corn husks!
In future the ethanol industry as a whole hopes to reduce its dependence on corn, swapping it for so called “cellulosic” feedstocks such as stover (corn stalks and husks left over after harvest), wheat and barley straw, forestry waste, sawdust, paper pulp, small trees and fast-growing grasses, such as hybrid poplars, willows and switchgrass.
One issue of particular concern in California has been the disposal of residue from rice crops. New laws mean that this can no longer be burned, and a new ethanol plant has been built to use this as a feedstock.
Cellulosic feedstocks would make the input costs of ethanol much cheaper, and hugely increase the availability of raw material. The available corn stover inventory is sufficient to support 7-12 billion gallons of ethanol production each year. That would go some way towards meeting the goal of the US Department of Energy, which is to reduce the cost of ethanol by as much as 60% by 2015.
If the US government is to hit its target, however, the ethanol industry must find more efficient ways of processing cellulosic material than exist at the moment. Today’s methods can require the use of sulphuric acid, and are expensive. So corn remains the primary feedstock. Some 14% of the US corn crop already goes to ethanol production, as well as 11% of the sorghum crop.
But ethanol isn’t quite the solution to America’s looming energy crunch that it’s sometimes cracked up to be. Fuels blended with ethanol cannot be transported through pipelines, because moisture in the pipelines and storage tanks is absorbed by the ethanol, causing it to separate from the gasoline.
So the supply of ethanol has to be transported from the mid-west agricultural states of the US by truck or rail, and then blended with the gasoline close to its final market destination. This not only adds to the cost of production, but it’s also used by ethanol’s opponents to support their claim that the production of ethanol-reformulated petrol actually uses more energy than it saves.
Still, ethanol has managed to take its contribution up to 3% of total US gasoline consumption. But this has relied on Federal and Sates subsidies. Petrol station owners are subsidised for converting their pumps to E10 or E85, and oil companies receive a tax credit – worth 5.1 cents for each gallon of E10 – for blending ethanol with gasoline.
Late to the party – a share to avoid
Last August George Bush signed the Energy Policy Act to create a national Renewable Fuels Standard. This targets an increase in the use of renewable fuels from a baseline of four billion gallons in 2006 to 7.5 billion by 2012, the great majority of which is expected to come from ethanol. This has encouraged the ethanol industry – but such has been the rush to build new plants that there are now fears of oversupply.
GTL is a latecomer to the ethanol party. GTL in fact stands for “Gas to Liquid” and the company’s original plan was to build a plant off the coast of Australia to convert gas into methanol, using something called Fischer Tropsch technology. Its other plans have included methanol plants in Vietnam and Oman, where it reckoned it could produce methanol for about $100 per tonne and sell it for twice as much.
That was five years ago. Today GTL’s website tersely says that “it has postponed work on its methanol project in Western Australia...[and]...is not involved at the moment in discussions to build a methanol plant in Oman.” Vietnam simply does not get mentioned at all.
But GTL’s history so far has been an object lesson in the perils of backing lofty ambitions. Its problems did not arise from gas-to-liquid technology in itself. Instead GTL found itself reliant on larger companies which have not always delivered on their promises.
It scrapped its plan to build a plant offshore in favour of a location near Darwin, Australia, on the basis that Phillips Petroleum would deliver oil from the Timor Sea through a new 500km pipeline. But Phillips then changed its mind, obliging GTL to switch the location to the Burrup Peninsula of Western Australia, a move which obliged it to negotiate land rights with local aboriginal groups.
Worse was to follow. Having proudly announced at an early stage that a buyer had been found for its entire production of methanol, the identity of this buyer turned out to be Enron, the fraudulent US energy giant which collapsed in 2001.
Bad luck piles up for GTL
More time was lost as GTL negotiated a new supply contract, this time with Vitol, which involved the long term chartering of two dedicated methanol tankers. That undertaking would have been enough to test any management team, especially one that had to come to
terms with the death of its chief executive, as well as sundry other retirements and resignations.
Continuing losses have seen GTL regularly return to the equity market to raise fresh funds, while at the same time trying to put together highly complex financial packages for its projects. Its messages to shareholders have contained a mixture of over optimism, exasperation and, in a desperate attempt to convince them that their money had not been completely wasted, it argued that “the value created by the project template and the various commercial relationships and credibility formed with substantial organisations such as Vitol, Mitsui OSK, and Société Général should not be underestimated.”
No surprises – this was not enough to stem the steady decline in the share price. But over the last year it appears to have hit the floor. On the basis, perhaps, that things could hardly get any worse, shareholders stumped up £24m last August to finance the acquisition of Illinois River Energy, the company that was building the ethanol plant. And apart from the attractions of the ethanol market, which incidentally GTL investigated back in 2000 but did nothing about, this move was justified on the irrefutable basis that it “is expected to produce revenues on a shorter timescale and at a significantly lower capital cost than the methanol plant in Australia.”
Effectively this marks a new beginning for GTL, and the question is whether this latest venture is a triumph of hope over experience. Certainly the risks seem lower. The technology for the production of ethanol is well established, and the plant is all but built, and within budget. Its value is now dependent upon the profitability of producing ethanol.
But as we’ve seen, this depends principally upon the cost of corn and the price of ethanol and the price of petrol. I can’t begin to tell you where the price of crude oil might be heading, but the price of corn is largely affected by the harvest, and has, in fact, been rather low recently. That’s allowed wider profits for ethanol refiners, with corn reasonably stable at around $2 per bushel.
Take note – this equilibrium could be disturbed by imports of ethanol from Brazil, however. Brazil makes its ethanol from sugar cane, but exports of ethanol into the US are currently barred by American import duties. That’s now been challenged by the Central America Free Trade Agreement.
Back in January broker Arden Partners put a value of 2.2p per share on GTL’s share price, using the conservative assumptions that the price of corn is 10% higher than its historical average, and that the ethanol price is 3% above its average. I accept that if the ethanol price were half as high again, that could be enough to double GTL’s share price. However, all the new plants under construction – plus the capacity additions about to come online, including GTL’s own application to double the size of its plant – will boost US ethanol production from 4.8 billion gallons per year to 7.4 billion gallons. This has led some brokers to warn that “the danger of overbuilding is a real one”.
“Too much money is available for infrastructure investments,” says one analyst, “and as a result ethanol prices are expected to fall rapidly from mid-2007.”
RHPS Verdict: Given its history, it is a miracle that GTL raised the finance to enter the US ethanol market. The future profitability of its plant is fraught with uncertainty, but one thing is clear – the supply of ethanol is growing fast. GTL’s plant has a large and growing number of competitors, and there are apparently few barriers to entry. So the chance of GTL making fat profits over a prolonged period seems unlikely. Despite the hype surrounding ethanol, GTL is not going into the RHPS portfolio today.
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