Ethanol is year's worst energy investment

Ethanol, the centrepiece of President George W Bush's plan to wean the US from oil, is 2007's worst energy investment.

The fuel tumbled 57 per cent from last year's record of $4.33 a gallon and drove crop prices to a 10-year high. Production in the US tripled after Morgan Stanley, hedge fund firm D E Shaw & Co and venture capitalist Vinod Khosla helped finance a building boom.

Even worse for investors and the Bush administration, energy experts contend ethanol isn't reducing oil demand. Scientists at Cornell University say making the fuel uses more energy than it creates, while the National Research Council warns ethanol production threatens scarce water supplies.

As oil nears $100 a barrel, ethanol markets are so depressed that distilleries are shutting from Iowa to Germany. An investor who put $10 million into ethanol on December 31 now has $7.5 million, a loss of 25 per cent. Florida and Georgia have banned sales during the summer, when the fuel may evaporate and create smog.

"I don't anticipate any sort of immediate rebound,'' says Barry Frazier, the 50-year-old president of Centre Ethanol in suburban St Louis. "It's going to take 12 to 24 months before the market is able to absorb the large amount of new capacity.''

The biggest producer, Archer Daniels Midland Co, may resort to exporting ethanol. Pacific Ethanol, backed by Microsoft Corp co-founder Bill Gates, dropped 71 per cent in New York trading this year as profits collapsed. Record oil prices, which make blending of ethanol with gasoline more profitable for refiners, haven't stemmed the declines.

"Ethanol companies are near break-even at best,'' says Ron Oster, a principal at Broadpoint Capital in Albany, New York. "That's not a good recipe when you have $100 oil.''

Corn has risen to $3.795 a bushel on the Chicago Board of Trade from less than $2.50 in September 2006. Ethanol on the exchange is little changed at $1.865 a gallon, after falling from a peak of $4.33 in June 2006.

The Bush energy plan spurred more production by mandating increased use of so-called biofuels, such as corn-based ethanol. The administration proposed raising output in the next 10 years to five times the current target amount for 2012.

Government Incentives
The US Senate approved the increase and lengthened the time frame to 2022. The federal government has 20 separate laws and incentives to boost ethanol use, and 49 states offer additional subsidies and supports, according to the Energy Department in Washington.

Scientists question the wisdom of using ethanol. Stanford University researchers say ethanol, originally added to gasoline in the 1970s to reduce tailpipe emissions, does nothing to improve the environment.

"It takes more energy to produce ethanol than it actually gives off,'' says David Pimentel, a Cornell University professor who has studied production of the fuel for two decades.

Ethanol is a form of alcohol indistinguishable from moonshine that's created by fermenting and distilling the starches from corn, sugar, wheat and other crops. Harvesting, crushing, fermenting and distilling corn requires 29 per cent more energy than ethanol produces, says Pimentel, a professor of ecology and agriculture.

Energy Gain
Michael Wang, an environmental engineer at the Argonne National Laboratory outside Chicago, says Pimentel is wrong to include energy spent on making fertilizers and pesticides. Ethanol production results in a 33 per cent gain in combustible energy, Wang says.

US ethanol inventories swelled to a record 10.3 million barrels in August as production jumped 32 per cent from a year earlier and demand growth slowed, the Energy Department said.

Restrictions on when ethanol can be used in Georgia, Florida and other parts of the Southeast are cutting demand by about 3 billion gallons a year, says Eitan Bernstein, an analyst at Friedman Billings Ramsey & Co. in Arlington, Virginia. That total is equal to 45 per cent of current national demand. Gasoline use is 142 billion gallons a year.

Tennessee and Arizona are among states that waived or modified rules to permit more ethanol use. Georgia Agriculture Commissioner Tommy Irvin in Atlanta has scheduled hearings for Nov. 27 and Nov. 28 to debate whether to relax fuel regulations. Florida is considering similar changes, says Matt Curran, chief of the state's Bureau of Petroleum Inspection.

'More Friendly' to Ethanol
"We're in the process of trying to make our laws more friendly to the ethanol producers,'' says Jill Stuckey, director of alternative fuels at the Georgia Environmental Facilities Authority.

Georgia and Florida may not increase ethanol use soon enough to deplete the growing supply, Bernstein says. Even with distilleries being canceled or scaled back, so many new mills are under construction that annual US output may reach 11.3 billion gallons by the end of next year, he says.

Indiana Governor Mitch Daniels in 2005 declared the town of Reynolds "BioTown USA,'' pledging to make the hamlet of 550 people a showcase for crop-based fuels.

Reynolds's municipal vehicles run on gasoline that's 85 per cent ethanol and diesel made from soybeans. Residents received incentives to buy General Motors Corp cars that can use more ethanol than conventional vehicles.

Closing Shop
Two years later, after ethanol prices tumbled to a 28-month low, VeraSun Energy Corp of Brookings, South Dakota, halted work on a 110 million-gallon distillery in the town.

Five other projects have been canceled since October 1, including an Alta, Iowa, mill for BioFuel Energy Corp, which sold shares to the public for the first time in June. The stock dropped 56 per cent since the offering, wiping out more than $190 million in market value.

The abandoned projects represent 539 million gallons of annual ethanol output, equivalent to 8 per cent of current US capacity, according to William Blair & Co, the Chicago-based investment bank.

Kari Elassal, a spokeswoman for DE Shaw Group, didn't respond to a message seeking comment for this story. The New York-based firm's holdings include stock in VeraSun, US BioEnergy and Sacramento-based Pacific Ethanol, which have declined an average of 60 per cent this year.

Pacific Ethanol fell 22 per cent in Nasdaq Stock Market trading today, leading declines by ethanol makers, after saying late last week that Gates may sell his stake.

No Financing
Metalmark Capital, which manages the Morgan Stanley Private Capital funds and controls a stake in ethanol maker Aventine Renewable Energy Holdings, didn't respond to a telephone message seeking comment.

Lenders have cut off funds for mills that weren't already under construction when prices began to drop, says Ron Miller, chief executive officer at Pekin, Illinois-based Aventine.

"Today it's very difficult if not impossible to get financing based upon these current margins,'' Miller said on an October 31 conference call with analysts and investors.

As the price slump prompts more distillers to shelve new plants, production growth will slow, allowing demand to catch up with supply, says Mark Miller, an analyst at William Blair. New production will peak in May, then drop to an 18-month low by October 2008. Prices will begin to rebound in July, he said.

"Through the first half of 2008, the weak margin environment will continue,'' says Christoph Berg, managing director at Hamburg-based commodities researcher F O Licht. "There are no real policy measures or easing of the feedstock markets on the horizon.''