News Analysis: Biofuels Trends to Watch for 2008

Biofuels investors have every reason to be sad to see the fourth quarter of 2007 fade away. Quarters like this one don’t come along all that often. An investor who simply took invested in the Biofuels Digest Index stock basket would be up 31.5 percent up as of December 21, compared to the last trading day in the 3rd quarter. Stock pickers who landed upon gems like VeraSun Energy (VSE), or picked up Pacific Ethanol (PEIX) in late October when it hit rock bottom just over $4, are up even more now that PEIX is trading at $8.92 and VSE at $17.75.

There’s no guarantee about the future except that all quarters won’t be so rosy. What are the factors that will make a difference in 2008, and what stocks are at risk or in play?

1. Ethanol tariff reform. This tariff keeps Brazilian ethanol from flooding the country at a significant discount the prices offered by US ethanol makers. Reform or elimination of the tariff has been much talked about, and its good news for Brazilian ethanol stocks like Cosan (CZZ), and bad news for domestic ethanol producers like Aventine (AVR), VeraSun (VSE), Pacific Ethanol (PEIX) and BioFuel Energy (BIOF). Pacific Ethanol is confined in distribution to the western states, and is less exposed to risk.

Bottom line: Don’t bet on tariff reform in an election year, but do bet on it for 2009 when the current tariff expires..

2. Biodiesel subsidy reform. US producers receive a $1 blending credit. They use it to ship export B99 and B99.9 to Europe and undercut the European competition. Understandably, European producers are apoplectic and have taken their case to the European Commission. US lawmakers have shown little interest in changing the subsidy scheme until 2009. Beneficiaries are the US biodiesel producers like Nova Biosource (NBF).

Bottom line: Since many biodiesel companies are private, exposure is limited. But expect the EC to shut down this loophole in 2008 one way or another.

3. Indian E10 mandate. India put an E5 mandate in place in October and proposes to increase this to E10 in October 2008. Oil companies have, to date, bought less than half the ethanol they are mandated to buy. If E10 is imposed and enforced, expect large scale importation to make up for the shortfall by an Indian sugar industry that isn’t ready for mass production of ethanol.

Bottom line: Expect E10 to be announced but be roundly ignored in 2008-09. Thereafter, consumption will pick up and that will help sugar producers as well as ethanol mills.

4. Algae oil cost of production. The Department of Defense estimates the production cost of algae oil at more than $20 per gallon today. If that gets down around $3 per gallon, that’s a sustainable resource that munches CO2 and could replace the entire US foreign oil supply. With those prospects in sight, expect a large number of companies with a toehold in algae to go public to raise large-scale capital for expansion. Currently among public stocks, Chevron (CHVR) and Boeing (BOE) are long on algae investment, and Shell (RDS) just announced JV in Hawaii.

Bottom line: As soon as algae drops below $8, start looking for an IPO to get into or consider going long on one of the oil companies betting on it.

5. E20 blend target. Earlier in the fall, US Sen. Chuck Grassley (R-IA) first raised the cry to change the US standard ethanol blend from E10 to E20. The Renewable Fuel Association has been looking into this possibility, and according to RFA president Bob Dineen, there are no “show stoppers” yet known that would prevent to country moving past the E10 blend wall. E20 is good for all ethanol producers, but especially those such as Aventine (AVR) and Pacific Ethanol (PEIX) that are not heavily invested in E85 fuels and flex-fuel vehicle technologies.

Bottom line: Expect a major announcement on E20 in 2008. The old adage is “buy on the rumor, sell on the news”. AVR, PEIX, BIOF, VSE, VRNM, and ADM are all set to benefit from E20.

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