The Age of Upstream

Not everyone is a winner when the dominant forces lie upstream.

What is the ideal relationship between feedstock producers and refiners? Has the balance tipped too far towards the upstream?

As the Algae Biomass Summit opens, we look at a global trend in transferring “All power to the Feedstocks!” – the advantages, options, and the potential for consequences.

You see it everywhere. Oil producers are happy, refiners are squeezed. Corn, soy and sugar prices are at historic highs, ethanol and biodiesel producers are squeezed. Iron prices are high, steel producers are challenged. Utilities are doing well, manufacturers dependent on electricity are in the tank.

We’ve heard about the Information Revolution and Global Warming, and the Green Revolution too –  but really what we are entering, if someone doesn’t do something about it soon, is the Age of Upstream.

How companies are faring upstream and midstream

Look, for example, at the performance of upstream companies like Syngenta, compared to midstream biofuels refiners like Pacific Ethanol.

Syngenta's two-year stock performance

Pacific Ethanol's two-year stock performance

What is causing the havoc for ethanol producers in the midstream? Prices for commodity feedstocks that rise faster than prices for commodity fuels.

We saw it in the price of fryer oil grease. At one time, waste oils could be had for negative cost. Restaurants were paying companies to dispose of it. Then it was available for free. Now it runs north of 30 cents per pound, or nearly $2.50 per gallon to the biodiesel producer.

Or, here, look at how corn processor Archer Daniels Midland has performed as a stock, compared to upstream-focused seed companies like Monsanto.

Monsanto's two-year stock performance

What is to be done with all that natural gas?

We see the debate between upstream and midstream taking place in the natural gas sector, where fracking technologies (for better or worse) have unleashed an abundance of supply.

The upstream view? US policy should be to unlock as much natural gas as possible and tap foreign markets via creating pipelines and export markets wherever possible, to turn a pile-up at the Henry Hub and $2.50 per MMBTU gas into a levelized global price of around $6 per MMBTU.

The midstream view?  Keep low-cost natural gas piling up in the United States, distribute it through the grid in the form of low-cost power that replaces coal, and leverage that cleaner, cheaper energy  into a competitive advantage for US manufacturers – to stimulate domestic sales and exports of finished goods, and bring outsourced jobs home.

We see it in the coal industry as well. As Reuters reports this week, ” Call it the Keystone of coal: a regulatory and public relations battle between environmentalists and U.S. coal miners akin to the one that has defined the Canada-to-Texas oil pipeline. Instead of blocking an import, however, this fight is over whether to allow a growing surplus of coal to be exported to Asia, a decision that would throw miners a lifeline by effectively offshoring carbon emissions and potentially give China access to cheaper coal.”

Return of the Jeffersonians and the Whigs

For students of history, if this sounds like a conflict between the pro-government, interventionalist American System espoused years ago by Henry Clay, and the anti-government, libertarian Jeffersonian Republicanism that Thomas Jefferson was the chief advocate for – well, that’s understandable. It may be a little strange that Republicans are, in many ways, Jeffersonians – and that the Democratic Party has gone over to Whiggery – but that is for the students of political science to consider and debate.

The Australian example

The Age of Upstream has been coming a long time. You can see it in Australia, where record resource prices have kept the Aussie dollar and the economy afloat. But the manufacturing decline is startling.

The pro-manufacturing Australian Party reports: “86% of cars on our roads used to be Australian made. Now only 21%. One of Australia’s biggest ship builders, NQEA used to employ 1000 people. Now 60. We were once 95% self-sufficient in oil, now we’re only 65%. Our mining industry was once almost entirely Australian owned, as was dairy, sugar, meat process, railways and major construction. Sheep numbers have dropped from 174 million to 68 million…exports of vehicles fell from $4.6 million in 2005 to $1.8 million in 2007 while imports of motor vehicles tripled from $1 billion in 2004 to $3 billion.”

Why are Aussies not rioting in the streets? Upstream business is good, the country is doing well — but worth noting that iron prices have dropped from a high of $187 per tonne last summer to $107 today – and that among the dangers of an economy overly predicated on commodities are the wildly gyrating prices.

What does this mean for biofuels?

First, we see a divergence in investment strategies. We see many companies like BP, Shell or ExxonMobil invested in the upstream. Shell and BP are now owners of vast sugarcane plantations as well as ethanol production. ExxonMobil – along with Shell and BP, have been exploring algae as a feedstock.  Flint Hills Resources has invested in jatropha via SG Biofuels, and BP has been investing in miscanthus via Mendel.

Then there are the midstream players. Take, for example, Valero’s interest in Mascoma or Diamond Green Diesel – both about everything except the feedstock, which is supplied by other partners. Or Petronas’ interest in LanzaTech – again, a company that supplies everything except the feedstock. In Italy this week, Eni has just announced the conversion of its Venice refinery from fossil fuels to biofuels, using the Ecofining process to produce renewable diesel.

What’s a stronger model? We suspect that the integrated model of novel upstream and midstream offers more protection against commodity price swings – and guards against the potential for upside down economics when feedstock costs rise above fuel prices. Also guards against the problem of getting trapped inside investments that lose — as in the case of Terrabon — their feedstock-providing investor.

But investing in upstream and taking on agricultural risk is not for the faint-hearted – it is highly capital intensive. So many investors have focused on the midstream processing technologies. Their hope? They believe their technologies are so unique – in liberating value from commodity feedstocks – that they will escape the fate of first-gen producers, and will be able to lock in a higher percentage of the value add than their first-gen brethren.

The build-out of the algae platform

In biofuels, the build-out of an algae platform is the most significant effort underway to develop a new upstream source of sugars and oils. This week at the Algae Biomass Summit, we’ll be measuring the progress of companies like Sapphire Energy, Cellana, Algenol, Heliae and BioProcess Algae, to name a few.

To date, the mission is both upstream and midstream in character. The most important companies are not only trying to grow algae on a sustainable, industrial scale – but developing novel technologies to fraction and refine the algae biomass into value-add products. It’s noble, expensive work, but companies like Solazyme are making it work.

Very few companies have, for example, focused exclusively on developing extraction and refining technology – hoping to buy affordable algae biomass in the long term on the spot market or contracting with producers. Those that are developing refining technologies are, rather, focused on selling them to algae producers – upstream. That’s where they understand the winning cards to reside. That appears to be the trend of the times.

You may well ask why — if algae producers and other companies that have embraced the upstream — are so well positioned, why aren’t they dominating the world? In many cases, they have yet to shake out sufficient cost from their processes to make products at market prices. But that is changing quickly as they acquire experience, capital and scale.

The bottom line

“All power to the Feedstocks!” – that is what we hear the world shouting. It sounds so much like “All power to the Soviets!” that one is forced to wonder if a “dictatorship of the upstream” will be any more successful than a dictatorship of the proletariat proved to be.