Beware the allure of ethanol investing

I am a fan of ethanol. The addition of corn ethanol to our US fuel supply chain has had a significant impact in keeping gasoline prices way lower than they otherwise would have been, and has paid for the subsidies many times over. But that has not translated to gains for ethanol stocks, which are down on the order of 50% over the last year according to the Camino Energy index, and it won't change anytime soon.

As the bellwether US ethanol pureplays are finally down to earth, and my predictions have come to pass. Two years ago ahead of Verasun's (NYSE:VSE) IPO, I blogged an analysis saying I thought Verasun should trade in the $3 to $8 range, depending on the margin, PE, and growth assumptions. The bankers and the market thought I was nuts, treating VSE and Aventine (NYSE:AVR) which listed near the same time as technology style growth stocks. The company listed at several times my target range, and then traded way up from there. But as I had predicted, the margin pressures from a range of commodity price movements and the relatively low barriers to entry for capacity additions came to bear. But the fall is probably not over.

I stated then and reiterate now that ethanol companies are basically small refiners with potentially worse economics. And refiners traditionally trade at single digit PEs, and single digit PE. Worse, refiners don't always do well when commodity prices rise or their markets grow fast, as the spreads they make their margin on are often affected as much by relative capacity contraints as the raw commodity prices themselves. In fact, fast moving commodity prices in either direction in either refined products or feedstocks can sometimes bode ill for refining profits, depending on what's happening in capacity.

VSE now trades under $5. Right in the middle of range I predicted it should. And the PEs for VSE and AVR are finally down in the range close to the independent refiners group I follow, Valero (VLO), Sunoco (SUN), and Tesoro (TSO). BUT. And there is a but. The TEV/EBITDA multiples for VSE and AVR, which are way down, are still 2-3x those of the refiners, and the PEG ratios are still richer as well. This likely means more room to fall, or at least languish.

The next wave of venture backed ethanol companies, mostly cellulosic, are beginning to break ground on pilot plants, and given the penchant for certain ethanol crazed venture investors to IPO deals when windows open, it is likely we will see some of these soon. And it is likely that they will be sold to the market the same way, as high growth stocks based on great technology and macro conditions justifying stratospheric PEs on unsustainable margins. Then they'll hit their first commodity cycle, the margins will compress, the bloom will come off the rose, the multiples will come down, and the investors who bought and held post IPO will get crushed.

We've seen it before and we'll see it again. Try not to get caught this time.

Neal Dikeman is a founding partner at Jane Capital Partners LLC, a boutique merchant bank advising strategic investors and startups in cleantech. He is the founding CEO of Carbonflow, founding contributor of Cleantech Blog, a Contributing Editor to Alt Energy Stocks, Chairman of Cleantech.org, and a blogger for CNET's Greentech blog.

[JMoore1984]

If I could, I'd be investing in Algae

[artie V]

You've forgotten to mention the rollercoaster called SunOpta (STKL). Been riding that rollercoaster for a while now. The core business unit is in organic food, but they also have legitimate operations and alleged patents granted for cellulosic ethanol production. If cellulosic ever comes around, it'll be good stuff. But for now, I'm banking on either expensive battery powered cars, new gen diesel engines, or further fetched hydrogen tech.

[lingsun]

Ethanol is an incredible waste of money. It shouldn't be subsidized. It should be imported from Brazil. It makes no energy sense to produce it in the U.S. Why waste fuel for tractors to grow corn to ferment it to burn it for fuel? Burn energy to burn corn? That's stupid. It's also making food prices a lot higher. There are poor people around the world that are starving partly because ethanol has made their food too expensive. It's also directly raised food prices in the U.S.

[123omg]

Also it kills the rain forest-Brazilians are eliminating the rain forest to make way for sugarcane and soybean crops. That releases an enormous amount of CO2 into the atmosphere. Ting sun is correct too...The food prices to us is just a burden, but to developing countries it means riots and death.

[billmosby]

A study from Iowa State shows that gas prices are "way lower" than they would have been without corn ethanol? Big surprise. By the way, a 40 to 60 cent per gallon decrease does not qualify as "way lower". Sure, it's not impacting food prices much now. How about when the goal of 5 or 6 times as much is being produced? Maybe that's why the link said that aspect is "a topic for another day". It should be a topic for today, while we can still kill the ethanol monster before it starves all but the ethanol sheiks out.

[pjk0]

Corn-based ethanol is a defective product sold to an unwitting public by the massively powerful US corn lobby. Corn is a really bad source for ethanol for a variety of reasons (some stated by earlier commenters), but since the US passed a law barring sugar cane sourced ethanol from being imported to the US, we're stuck with this nonsense right now.

The whole world will abandon this - including sugar-cane sourced ethanol - as soon as people wake up and realize how dumb it is. Meanwhile, the speculators have the last laugh..

[suyts]

Why don't we let corn be a food source and just drill more oil. We import 750 million barrels of oil each year. There is an estimated 86 BILLION barrels off the coast of Florida alone. Coastal Florida could solve our oil import difficulty for over 100 years, open some refineries and the immediate problem goes away. This would allow us time to mature industries and technologies that allow for alternative fuel sources. Kind of a no brainer. Cheap oil, cheap fuel, energy independence, less stress on the food prices and increased employment in the U.S. Naw, we don't want to do that. I know, let's take food out of the out of the food supply and make a less efficient fuel with it. I don't buy the "ethanol = cheaper gas prices" either. It takes almost 1/2 bushel of corn to make a gallon of fuel. Corn is trading over $6/bushel. So, before any transportation or processing or refining, ethanol is coming in at about $3/gal. at about 85% efficiency How is that going to drive the price of gas lower? It doesn't..

[rickolano]

Corn ethanol is a diversion away from far better alternatives.