Why don't oil majors invest in biofuels at scale?

In recent weeks we have tracked the significant number of migrations among early stage biofuels producers from a “fuel centric” strategy to an emphasis of renewable chemicals, organic acids, food oils, and nutraceuticals.

We sometimes think this publication ought to be renamed “Bio-High-Value-Co-Products-or-anything-please-God-that-makes-money-quickly Digest”.

Case in point: Didn’t there used to be a Blue Marble Energy, a group of Seattle-based entrepreneurs and scientists who aimed to harvest wild algae for a fermentation process that would produce renewable fuels, and some specialty chemicals. They launched an algae-based fragrance last year during the holiday season, one of the more interesting bio-based products of the year.

Yep, those guys.

They recently re-emerged as Blue Marble Biomaterials, following an exemplifying a trend where small renewable fuel technologies are being re-purposed towards the specialty chemicals market.

Amyris and Gevo are touting their chemicals capabilities in their IPO filings over the past three months. Cobalt Biofuels has been rebranded under Cobalt Technologies (actually, its original name) – while companies like Myriant have attracted huge talents from the renewable fuels space.

What didn’t happen to all the early stage biofuel companies?

For sure, it’s not like the chemicals business had a wave of price surges, or the delta between fossil-based chemicals and fossil-based fuels changed dramatically. Nor have some of the formidable competitors in chemicals – respected, feared giants like Dow, Dupont, or BASF – exited the market or slacked off in their sales push. Nor has the volatile nature of the chemicals market pricing changed all that much.

What did happen?

Blue Marble’s effervescent CEO Kelly Ogilvie, well known on the renewables circuit for his high-energy presentations over the years, took us through the math.

“Over the past 18 months,” he said, “while we have been developing our technology, we have been watching the gen one failures in the fuel space. The whole business of producing a low margin product (like fuel) at high volumes is challenged, in many ways it is not working. Especially if you are raising equity. There just isn’t lots of money for lots of volume any more.”

Sounds about right. In series like Benjamins for Biofuels, we have been tracking the substantial financing woes of the developing fuel side of the industry.

But in chemicals, investors are pouring it on. According to the CleanTech Group, VC invested $361 million in renewable chemicals during the first half of 2010. Their report opined: “While capital intensity had been a concern in the past, the sums required to reach commercialization are considerably less than in many other sectors such as biofuels,” the report said.”

“You have to ask yourself,” Ogilvie muses, “what is the market saying? It’s saying: less risk. Build smaller facilities. But how do you make that model sustainable. Higher value products, and find a high-end where no one can produce it as well as you.”

Another escapee to the Land of Misfit Toys

Recently, the ranks of the Misbegotten grew by one more, when Aurora Biofuels checked out, and Aurora Algae was born.

Food, fragrances, chemicals and, oh yeah, right at the end of the list, fuels.

“Why make a $2 fuel when you can make a $5 chemical?” Cobalt Technologies CEO Rick Wilson commented in a recent interview with the Digest. Elevance confirms that it is able to sell some of its soy-based chemicals for as much as $4.50 per gallon.

But in this case, Aurora is looking primarily at food. According to the always entertaining and well informed Michael Kanellos at Greentech, “the company is in the midst of a reorganization, according to sources. When it emerges, Aurora will put a strong emphasis on growing algae for omega-3 fatty acids and proteins for the dietary supplements market. It will also sell cell mass as animal feed.”

Is this the end for biofuels pure-plays?

It may well be the end of the road for some, but hardly for all. It simply is the end for companies whose technology couldn’t show the internal rate of return necessary for scale in fuels. But whose IP could be neatly repositioned around the high-end co-products. Hence Cobalt, Blue Marble, and perhaps now Aurora.

But we see acceleration in the fuel space as well. Joule is not slowing down – if anything, it is accelerating. Why? A technology competitive with $30 oil that makes ethanol suitable for meeting obligations under the Renewable Fuel Standard. That’s why.

Others, like Amyris, LS9 and Solazyme? They are hanging tough with fuels, though they all have extensive programs based around the creation of fragrances, surfactants, food oils or pharmaceuticals. But they are not quite heading for chems now, fuel later. They are doing both, in parallel.

The oil investor conundrum

In all of this, biofuels developers bemoan the absence of investments from oil majors, taking available technologies to scale. True, BP has Butamax, but it wants someone else to put up the capital to go to scale. Shell has held onto its 50 percent investment in Iogen for six years since the that project’s pilot debuted, but has not written the check.

Why?

According to Digest sources at oil majors, the reason that companies like ConocoPhillips, Marathon are “blowing retreat” on biofuels  has little to do with attitude towards or the economics of biofuels. It has to do with the massive profits available in developing upstream assets in traditional oil & gas.

Back in the days of the Bush Administration, there was a feeling that $100 oil was a  given and that $200 oil was not out of the question. It was thought that $200 oil would create that rush for biofuels that is lacking today.

But $200 oil would make the problem worse. You see, as challenging as the midstream refining business becomes during days of $200 oil, and as murderous as the downstream retailing of gasoline or diesel becomes in times of high prices, the upstream business of exploration and discovery becomes a goldmine. Assets that were unproved reserves become proved (that is, economically recoverable), and proved reserves go from nicely profitable to wildly profitable.

The more expensive that oil becomes – and the more that the public hates it – the better the economics look for oil majors who have focused themselves on the upstream side of exploration.

Even at $75 oil, more than double what oil cost just 15 years ago, the upstream opportunities are so strong that oil companies can make 50 percent annual returns on investment, and recover virtually all the massive profits available, within seven years. According to Digest sources, good upstream opportunities are so good right now that it is more profitable to pay fines for missing RFS targets out of the proceeds from oil exploration, than to develop assets in biofuels.

So, what next?

There are three thoughts to consider. First, not every oil major is as well positioned as the others in terms of their upstream assets. The worse their opportunities are, the better biofuels look.

Because it is essential to remember that biofuels are above-ground oil fields – a different kind of proved reserve – that is to say, a renewable one. When the IRR of biofuels projects begin to exceed the upstream opportunities available to oil majors, that’s when scale will happen.

So, in looking for an oil major to take you to scale, look at their proved reserves, and aim for the weakest link.

Second, ironically it is low oil prices that might shake up the equation. $30 oil leaves a lot of oil majors out of position, in terms of matching assets to growth. Oil majors have to grow, and to do so they need proved reserves. The less they make from traditional fossil fuels, the more they need from alternatives.

Third, in the grand tradition of “send in the cavalry”, the very thing we fear – the nationalization of oil assets by nefarious regimes, is a catalyst for alternatives. Whether national oil companies simply seize assets, or develop or buy them, is of no import. The less that independent oil majors can gain from offshore shelves that pass under the control of Sinopec or Petrobras, the more they need alternative sources to feed their growth. You want investment in alternative energy? Cheer on Chavez.

Fourth, not every strategic investor is an oil major. Some are customers of oil majors – mighty scared of the prospect of $200 oil, and none too happy about $75 oil either. Chemical companies, agricultural commodity conglomerates, and the foodies. When oil prices rise, so too does their interest. They are the Yin to the oil industry’s Yang. With prices in the $75 range, they are dabbling without diving. Come $130 oil, look for the likes of Dow and DuPont to amp up the investment. Though they can pass along costs to the customers and have been daeling with price volatility for a long time, long term high oil prices ultimately cut into the demand coming from their traditional products and markets. Biofuels – and biochemicals – are a hedge.

So, there we have it, the rollercoaster of investment. High oil prices, look for the customers of oil companies to look fondly at the bio-world. Come a crash in prices, and oil majors have fewer tempting offers elsewhere.

What do they have in common – all companies want growth, need growth, and prefer stability. Those are the sine qua non of rising share prices, and happy shareholders. So don’t feel upset when your friendly local oil major is not investing as much as it could in the biofuels space. Simply look at the growth rate they need, and wait until their proved reserves no longer meet that need. That’s when they will come a-calling.

The key to alternative energy is understanding that companies invest when they need alternatives, not when you do.