Why Conventional Ethanol Policies Are a Scam

It's promoted as the answer to energy independence.

It's touted as the solution to global warming. It's hyped as a way to actually clean our air. It's a bird... It's a plane...

It's corn-based ethanol. And unfortunately, it's a scam.

Okay, "scam" might be a little harsh. Let's just say ethanol is an inefficient alternative fuel that can't possibly live up to the hype.

The hype climaxed this past summer as the shares of every company even remotely involved in the production, transportation, or marketing of ethanol surged to all-time highs. The shares have since fallen back down to Earth. In fact, most of the stocks have given back as much as 60%-70% of their gains.

The declines suffered by the likes of Pacific Ethanol and VeraSun Energy have been so severe that I thought I might be able to find a few bargain-basement ideas in the ethanol sector recently.

I was wrong.

The economics of the ethanol industry are simply not suitable for longer-term investing, say, five years or more. But first, let me tell you why the general furor over ethanol will be short-lived.

You see, creating ethanol involves taking feedstock – typically corn or grain – and heating it so that the sugar in the feedstock separates from the starch. Yeast is added to ferment the sugar to ethanol. Then the ethanol is distilled and the water is separated from the mixture through dehydration. It's a relatively simple process. But there are two main elements that make it inefficient from a cost/benefit perspective...

1. Using corn as feedstock is expensive: Corn is limited in supply, and there are other demands for it, such as a food source for humans and cattle. As the price of corn increases – and it's currently trading at record highs in the spot market – the cost of producing ethanol increases.

2. Natural gas is used to heat the feedstock to separate the sugars from the starch: This process uses about two-thirds of the amount of energy that ethanol generates. Many studies suggest that if you add to this the energy that it takes to grow and transport the grain, then ethanol just barely generates a bit more energy than it consumes.

Like I said, it's an inefficient alternative fuel. But don't bother telling that to the folks in Washington. They love the idea of ethanol. After all, in Washington, D.C., no bad idea goes unfunded.

When it comes to investing, politics do matter. The party that controls the legislature gets to decide which pet projects to invite indoors to lie down by the fire and which pets to kick to the curb. And, under the new regime in Washington, no pet is more spoiled than renewable energy – aka, ethanol.

Not that Republicans abused the creature. In fact, the ethanol industry benefited quite well from the Energy Policy Act of 2005. But under Democratic leadership, Congress likely will expand many of the act's mandates, such as the increased use of ethanol as a fuel additive. And that means it's boom time for the ethanol industry.

Already, companies including VeraSun, Pacific Ethanol, and Aventine Renewable Energy are announcing record revenues and record profits. But it won't last.

Here's why the spike in earnings is temporary: Markets work. It doesn't take long for a spike in demand to quickly be met by a spike in supply.

Record profits and revenues attract competition. Currently, 102 ethanol plants are in operation, 32 are under construction, and another 127 are in early planning stages, according to a recent Dow Jones article.

If all those proposed plants come online, they'll soon be producing about 16 billion gallons of ethanol per year. That's four times the 2005 level and more than twice the amount required by 2012.

It'll take about 5.7 billion bushels of corn – roughly three times the amount used in 2005 – to create that amount of ethanol. No wonder corn prices are at record highs.

And with corn prices at record highs, ethanol production is much less profitable.

So we're rapidly moving from a situation where oil companies were scrambling to buy ethanol at any price in order to comply with the MTBE replacement mandate to one where producers are flooding the market with about twice the supply to meet the required demand six years from now.

Do the big swings in sentiment towards alternative fuels give us low-risk trading opportunities? Sure. But it's not a situation that offers a lot of promise for long-term investors.

Just because ethanol stinks as a fuel doesn't mean we can't make money here. After all, the public's love of ethanol – and the politicians' desire to appease the public – all but guarantees the corn-based ethanol scam will continue. In tomorrow's edition, I'll show you the best way to profit.