Biofuels Digest analysis: Are you well-hedged in your biofuels investments?

In a sector like biofuels where the company value is closely linked to commodity prices and therefore subject to high volatility, hedging is an essential component of investment success.

It’s well known that pure-play ethanol stocks have struggled this year and some have lost more than half their value in the last three months. But an investor who bought the Biofuels Digest Indexâ„¢ stocks in exactly their market value proportion would be up, not down, during this tough period. And up strongly, for the Index is up 5 percent in the past 90 days.

But good hedging isn’t just spreading risk in your portfolio; it is spotting the smart hedging strategies at every company you buy.

By picking smart hedgers for your portfolio, you’ll be well hedged too.

What’s an example of a smart hedger in biofuels? Well, for example, imagine how much better the financials will be for US ethanol producers who contracted three years ago for a long-term corn feedstock supply at 2005 prices indexed to inflation.

If they had paid as much as $2.50 a bushel, I’d be mighty surprised. Today, corn is priced at $3.89 for December delivery, and the long-term hedgers are looking awfully smart.

How are the smart companies hedging their bets?

1. Diversification. Companies like Archer-Daniels-Midland (ADM) and The Andersons (ANDE) have just a portion of their operations in biofuels. When times are good, as they were in 2006, A-D-M recorded 25 percent of their profits from biofuels and caught a ride on the sector’s expansion. When corn prices caused trouble for pure-play ethanol stocks in 2007, A-D-M relied on strong results from its traditional business units to grow through tough times. Since August, while pure-plays have lost as much as half their market value, ADM is up 15 percent while The Andersons is down only 6 percent.

2. Field-to-wheels ownership. Look for stocks that cut out the middleman at every corner, and in particular own the most volatile piece of the value chain, which is the underlying feedstock. A company like D1 Oils (DOO.L) is gobbling up contracts and land for jatropha production in Africa and Asia – they’ll be less exposed if other biodiesel feedstocks like palm oil continue to rise in price.

Alternatively, a company like VeraSun Energy (VSE) owns its own E85-branded ethanol, VE85, making it possible to partner with supermarket chains like Kroger to distribute their fuel at retail prices, which are far stronger than wholesale prices as of this writing. E85 is typically priced at a 15 percent discount to gasoline at the pump, but was discounted 25 percent to gasoline in the wholesale markets a few weeks ago.

3. Right sizing. In the biofuels game, you can succeed as a large company, or as a medium size, or even as a small producer or homebrewer. But beware the mid-sizes: medium-large or medium-small. While A-D-M is large enough at a 4 billion market cap to be highly diversified and up 15 percent in a tough ethanol market, The Andersons with a $1 billion market cap is not quite as diversified and is down 6 percent although featuring sound management and a good strategy. Among the pure-plays, VeraSun Energy built just enough production capacity and is down 11 percent since August, while Pacific Ethanol (PEIX) is too large to contract easily in tough times, but too small to achieve sufficient economies of scale. Result? PEIX is down 51 percent since August.

4. Second-generation biofuels investments. The best long-term hedge is to be fully invested in next-generation biofuels: algae and jatropha-based biodiesel, and cellulosic ethanol. Companies like VeraSun (VSE) have made smart investments in cellulosic that will pay off, but look for private companies that are “all-in” on cellulosic, like Verenium (VRNM) to “cash in” big. Look also for cellulosic ethanol pioneer Mascoma to think about an IPO in 2008.

5. Exporting. With the dollar taking a swan-dive into historic lows, US exports are cheaper and imports are more expensive. The Euro, for example, has risen more than 40 percent against the dollar in this decade.

Look for companies that can produce in the US, collect a $1 per gallon blending tax credit in the US, export to Europe, take a biofuel credit there and sell into an expensive currency based on a cheap one. Sounds like a job for BP, although they have been slow to ramp up production in the US because they have placed their biggest bets on biobutanol, which is still largely in the development stage.

As said at the beginning of this article, the best way to hedge well is to pick stocks that are well-hedged. Look beyond the charts to see where their sales are recoded, their R&D is spent, and their acquisition dollars are directed, and you’ll know well how to “hedge for success”.

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