Ethanol: A Risky Business

Washington seems poised to help producers of the alternative fuel prosper, but risks from commodity prices to politics leave investors leery

by Moira Herbst

In his State of the Union address, President Bush pleased some audience members by proposing to radically increase the amount of alternative fuel usage. Corn Belt congressional folks beamed and cheered their approval. So did their constituents, producers of ethanol, the biofuel expected to fill most of the gap created by lower gasoline consumption.

And with good reason: Were it to become legislative reality, Bush's call on Jan. 23 for 35 billion gallons of alternative fuels in the U.S. economy by 2017—nearly seven times current capacity—would guarantee ethanol producers and corn growers strong demand for at least a decade.

Ron Miller, chief executive of Aventine Renewable Energy Holdings (AVR), a leading ethanol producer, was among those who welcome Bush's proposal. Aventine supplies and markets more than 500 million gallons of America's ethanol supply to major integrated oil companies like BP (BP) and Exxon Mobil (XOM).

"The president got his arms around a realistic goal to get us to focus on solving the energy dependence problem," says Miller, who took Aventine public last June after starting the company in 1981. "It's a stretch, and it'll take effort, but it's achievable."

Skepticism Aplenty

But despite the feel-good rhetoric of energy independence and a more environmentally friendly future, Wall Street remains skeptical. In the days preceding Bush's speech, the shares of ethanol producers surged, but by Wednesday they headed down sharply, and continued the descent on Jan. 25. Aventine's stock has taken a particularly low dip. Having opened at $43 with the company's initial public offering last June, the shares have since lost more than half their value. The stock fell another 8.4%, to close at $16.24 Jan. 25 on the New York Stock Exchange.

Other ethanol producers suffered a similar fate. Shares of VeraSun Energy (VSE), which went public last year at $30.75, fell 2.6% to close at $17.49 Jan. 25. Pacific Ethanol (PEIX), a California-based refiner of corn-derived ethanol whose stock hit $44.50 last May, has fallen to $16.53. Archer Daniels Midland (ADM), the largest producer of fuel ethanol in the U.S., declined less than 1%, to $31.82, after having rallied 2.6% just ahead of Bush's speech.

Investors have been skittish about ethanol because they're concerned about the short-term obstacles to the industry's profitability, analysts say. "These stocks rallied ahead of the news more because of trading and gamesmanship than people investing in the long run," says Chris Shaw, an analyst at UBS (UBS) who covers ethanol producers Aventine, VeraSun, and Archer Daniels Midland. "[Bush's] speech suggests a strong long-term demand, but it's not clear how profitable this industry is. The most important factor long-term is that it's a commodity industry; expansion requires favorable market conditions."

Price Volatility

Ethanol's profitability is also linked to corn prices, which have been steadily rising, now trading at about $4 a bushel. The conundrum for ethanol producers is that ethanol demand is driving up corn prices by gobbling up supply—thus making production more expensive for companies trying to boost capacity (see BusinessWeek.com, 1/10/07, "Commodities: Who Profits from Corn's Pop?"). The 5.3 billion gallons of ethanol produced in 2006 consumed nearly one-fifth of the U.S. corn crop. And if the new ethanol plants currently slated for construction go into operation by next year, about half the corn supply will be used for ethanol.