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The Compression Spread

| February 8, 2013

KiORYou’ve heard about the crack spread, and the crush spread — as means to value oil refining and crop refining.

Let’s think about biomass densification and compression, and in that context, a little about KiOR.

You might have heard a little or a lot about KiOR — which is currently commissioning its first commercial-scale (11 million gallon) biofuels plant in Columbus, Mississippi.

Now, the oil industry might, via the American Petroleum Institute, be currently talking down the validity of the Renewable Fuel Standard — but it is not entirely clear that KIOR would have found the financing that it did without the EISA Act galvanizing investors into action.

KiOR’s secret sauce

Now, it is getting more clear — among all the glittering pieces of technology that the biofuels industry has developed — that the oil refining and marketing sector would really, really like to have invented KiOR’s BFCC unit — KiOR’s secret sauce.

What is a BFCC? It is a fluidized-bed catalytic cracker that works with biomass (in KiOR’s case, they are working now with southern yellow pine they expect to obtain at $72 per bone-dry ton).

KiOR-graphic

Why is it coveted? It takes biomass, which has low density, and liquifies it into an intermediate with very high energy density — and does so at a transformatively low cost. That intermediate can be hydrotreated into an in-spec drop-in fuel — either in the gasoline range, or diesel, or even jet.

Why is that important? Because it is expected to be available at a lower cost than the marginal cost of oil production — when taken to an appropriate scale.

Equally importantly — because it is produced from renewable biomass — it can help de-carbonize an atmosphere that is producing increasingly wacky weather.

The marginal cost of producing oil

In a world where oil prices are highly volatile, one statistic for price prediction has held true for a long time — and that it is averaged cost of marginal production of oil for the world’s 50 largest public oil companies.

What exactly does ” the marginal cost of production” mean? It is the cost of exploring and capturing the last barrel of oil needed to meet overall global demand.

Bernstein Research circulated a note last year estimating that the marginal cost of production (for the top 50 public companies — note that some national oilcos have very different cost structures) increased by 229 percent between 2001 and 2010. Meanwhile, oil prices increased by 228%. Eureka — a driver of long-term oil prices.

It stands to reason. If the oil price falls below the marginal cost of production – production stalls until the price rises. That’s simple economics.

All that lovely Bakken crude

Further, it is not as easy as many suppose to disrupt that price with, for example, an explosion of oil production in the Bakken oilfields of North Dakota or the tar sands of western Canada. Bakken crude sells at a very deep discount, already, to Brent Crude — the spread has exceeded $30 per barrel at times.

That’s because of the lack of pipeline and railcar capacity to move it to international markets.

Which brings us back to KiOR — and the possibility that, long-term, the future of the company may focus less on building complete field–to-wheels fuel capacity via hydrotreating intermediates onsite, at its own facilities.

It has a future — perhaps a very big one— not so much as a supplier of finished fuels to its own customer base of fuel buyers, but as a supplier of crude-equivalent feedstocks to existing refinery infrastructure.

That’s where that $92 a barrel becomes important — not the $100-$115 retail value of the barrel, but the production cost of that barrel.

Recovering prehistoric algae as an energy business

You see, at the end of the day what you get from punching holes in the ground (i.e. oil exploration) is a well tapping into some prehistoric algae which — over 60 million years or so — has been transformed by Nature into crude petroleum and natural gas.

Nature made the biomass for free — via its own cocktails of carbon dioxide, water, and trace nutrients. Then, Nature conveniently densified the biomass for free, too. What we pay for is the harvest — it’s the energy equivalent of hunter-gatherer.

With a barrel of oil, you get around 5.8 million BTUs. That’s around $15.86 per million BTUs for the marginal cost of production.

In the case of KiOR, you have to pay for the biomass — the aforementioned $72 for each bone-dry ton. In that ton, you start with 14-20 million BTUs. So, you are paying $3.60-$5.14 per million BTUs for the wood.

The problem is, you can’t burn wood in a car engine — and even if you could, you think range anxiety for battery-electric vehicles is bad. Sheesh!

So, here’s the challenge, and here’s the prize, and a caveat.

Challenge? Densify the wood biomass into a crude-equivalent refinery feedstock for less than $12.72 per ton of biomass, including your operating and capital costs and your cost of capital.

Prize? Well, the International Energy Agency expects that energy demand will rise some 50 percent over the next 25 years — rising demand that you can serve.

Caveat? Lowest-cost producer wins. No one is likely to buy your $92 per barrel intermediate if there’s a $90 barrel available.

Catalytic fast pyrolysis

Where does this all lead us? In the case of making crude-equivalent intermediates — catalytic fast pyrolysis has emerged, of late, as the lowest-cost path towards answering that challenge. It is not entirely clear this class of technologies will actually reach scale — and reach the targeted costs — and find boatloads of affordable capital any time soon. But the signs are quite encouraging.

Catalytic fast pyrolysis — that’s what KiOR does. That’s why so many people watch their development with such attention. Why there is such an intense interest in their progress that media have been snooping around the plants, trying to get information on production prior to the company’s quarterly earnings call (earnings are expected to be reported March 25, according to NASDAQ).

Other paths to biofuels heaven

Nor is it entirely certain that crude-equivalent intermediates are the only viable path to market. For instance — there is the entire class of alcohol fuels, which are controversial in the US and the EU because of infrastructure issues, but are well-established in Brazil.

Crude-equivalent intermediates certainly are attractive — if one of your goals is to avoid finding out how much the oil & gas industry is willing to spend to send you to the devil, if you come up with a technological path to affordable meeting transportation fuel demand that doesn’t pass through oil refineries.

The oil industry’s anguish over alcohols is as profound as the Prohibition Party’s anguish used to be.

Back to KiOR

So — that brings us back to KiOR, and its prospects. We’ll know quite a lot more on the next earnings call. For now, they are in the business of making finished fuels and earning revenues from RINs and fuel sales.

For sure, right now they are proving the validity of their process to investors. One might speculate that they are also surrounding their IP — their secret sauce — with a complete path to market so that never become the captive of a refiner & marketer who can form a barrier to entry between their crude and the downstream gas station. With ethanol producers we have seen, ahem, where that can lead.

Long-term — we don’t see a process that can turn that much southern yellow pine (and other biomass, down the line) into sub-$92 crude-equivalent intermediates having a market cap of $584 million, as KiOR has today. If the technology does not work out — well, it’s not very valuable, is it? But if it does work out – as sports broadcaster Keith Jackson used to say “Whoa, Nelly!”.

Why? Looked at it as a technology that converts resources into proved reserves (valued at, say, $20 per barrel, or the spread between Brent crude and the marginal cost of production) – KiOR is valued at around 29 million barrels of oil. That’s the volume of oil you get from converting 400,000 tons of wood into oil refining intermediates.

But there’s a lot more wood out there.

The above-ground oil field a/k/a the US wood basket

The US Department of Energy, in their Billion Ton update study in 2011, estimated that there would be 120 million tons of wood biomass available, per year, at $80 per ton, that could be sustainably used for bioenergy. The figure declines to around 85 million tons at $40 per ton.

That’s a big spread.

So — in all things biofuel – keep that cost of densification very much in your mind.

The Compression Spread.

In traditional oil and agricultural economics, we think about the the cost of liberating a known molecule. In the new bioenergy — getting biomass sufficiently densified, via technology instead of Nature — may open the door to ultra low-cost feedstocks and some amazing upside value for the liberators and their inventions.

That’s the compression spread.

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