The Lowdown on Biofuel Subsidies and Mandates

Since the biofuel industry is young and capital-intensive, subsidies and mandates have been put into place to reduce the risk for investors, and increase the availability of capital for the rapid expansion of the industry.

The good news? Ethanol and biodiesel production has boomed in the United States. Ethanol production will reach 5.6 billion gallons this year – not a gigantic dent in the overall national fuel demand of 140 million gallons – but an impressive start.

The bad news? Ethanol pure-plays like Pacific Ethanol (PEIX) are not exactly swimming in profits. In fact, their gross margins are down alarmingly thanks to the increased cost of corn and the reduced price of ethanol on spot markets as more production comes online. That’s one of the reasons why pure-plays have “risk” written all over the reports from analysts who follow their stocks.

Pavel Molchanov, biofuels analyst for Raymond James, says ” At current ethanol and corn prices, we estimate that a typical U.S. ethanol producer is generating negative EBITDA of about $0.06/gallon….We are still not ready to call a bottom in the crush spread (currently $0.41/gallon, down from a 52-week peak of over $1.10/gallon in May), but we believe that the bottom is not far off.”

The drop in ethanol demand has the infant ethanol industry crying for more mandates, and holding desperately onto their incentives for dear life.

Subsidies and mandates are powerful forces on the balance sheet and income statements of young companies in a young industry. So, investors have the difficult job of not only understanding the profit potential of the company: they have the second duty of figuring out what level of incentives and mandates will be continued and to what extent that will alter the profit outlook.

Subsidies and mandates always good for the bottom line? Not so! Incentives are good for industries, but they can produce disastrous overcapacity and competition for some companies that find themselves in the wrong place at the wrong time.

Good subsidy and mandate structure encourages the industry without creating investor exuberance and without rewarding bad companies.

Let’s see where we are, where we are likely to head, and what that means for the biofuels investor/

Where we are
In the United States, we have a Renewable Fuel Standard (RFS) that mandates the sale of 7.5 billion gallons of alternative fuels by 2012. This translates to about four percent of the market. We also have a 51-cent per gallon blender credit that goes to fuel distributors who blend ethanol with gasoline, and a $1 per gallon blender credit for biodiesel. Many individual states have even stronger biofuels mandates in place, and some states offer additional subsidies.

Where we are going
The US House passed a 2007 Energy Bill that kept the ethanol and biodiesel subsidies while reducing the ethanol subsidy by a nickel a gallon, but did not propose a new RFS. The feeling in the House was that the biofuels industry should have subsidies, but no longer needed mandates.

The US Senate passed a version of the Energy Bill that continued the subsidies and set a new RFS of 36 million gallons of renewable fuels by 2015.

The House and the Senate conference to resolve differences in the bills collapsed in confusion. The House ultimately passed a new 25 x 25 mandate that 25 percent of all fuel should come from renewable sources by 2025; meanwhile, the Senators Obama and Harkin have introduced a new Senate bill with an RFS of 18 million gallons by 2016.

What it means for you, the biofuel investor
Subsidies are good for producer stocks because they make US producers more competitive. Right now, the betting is that the subsidy on ethanol will be reduced; so, if not, think about large-scale, pure-play ethanol stocks like PEIX, AVR or VSE that will be suddenly undervalued.

If subsidies are dropped on ethanol, that will make biodiesel perhaps a stronger component in the overall drive towards renewable fuels. If so, look to see upside for companies like BBDS.OB and NBF that are pure-plays on the biodiesel side.

If a 16 million gallon mandate for 2016 goes through, that means corn ethanol will have to carry a lot of the weight because second0generation cellulosic ethanol technologies and diesel engine improvements will not have had time to gain market traction. So again think AVR, PEIX and VSE, but also give ADM some consideration as Archer-Daniels-Midland is the biggest player in the sector and makes 25 percent of its profits from biofuels. Also, look for a lot more E85 blended gasoline as companies try to shove ethanol out there to meet the mandate. That’s good for VSE, which has its VE-85 brand, but not good for Shell, Chevron, Exxon and BP, which are betting on second-generation biofuels. It’s also for GM, which has established leadership in flex-fuel cares that run on E85, plus there’s hope that automakers would escape a capital-intensive lift in CAFE standards if we achieve emission reductions via biofuels instead of engine technologies. Subsidies also help oil company stocks because they own blending facilities and are the actual recipient of the blender credit.

In mandates are set with a longer time horizon, then the oil companies look better, and diversified companies like ADM which have hedged their bets in second-generation biofuels projects will look more attractive.

Whatever you feel will happen, it is important to always grasp that no matter what happens to incentives or subsidies – expanded, renewed, or dropped – they matter enormously in the investment decision, and understanding what is about to happen in Washington is one of the best ways to make money investing in biofuels for the next several years.
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Jim Lane does not own any of the stocks discussed in this article.

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