Should You Invest in Ethanol?

Despite President Barack Obama's best efforts to the contrary, ethanol isn't a very popular energy source. It's generally cheaper than gasoline, but the advantages mostly end there. It burns cleaner than regular gasoline, but the total environmental impact is about as bad, considering the energy-intensive process of creating it. It has problems traveling through existing gas pipelines, so it has to be shipped by truck, further negating some of the environmental benefits. The most damning issue with ethanol is that it serves as a bridge between fuel for people and fuel for machines.

About 40% of the corn crop in the United States will be used for ethanol production this year, up from just 8% a decade ago. The actual crop has not risen nearly enough to absorb that much extra demand, leading to a doubling of the price of corn. And because the price of corn is so high, farmers are incentivized to plant more of it than they ordinarily would, crowding out other crops such as soy, which has also doubled in price as supplies become constrained. To a lesser extent, the increased demand for corn has also contributed to the rising price of inputs such as fertilizer and farmland, as well as products that must cope with rising corn prices, such as livestock.

Problems at the pump
Despite all that, ethanol companies have one major thing going for them -- ethanol-blending mandates. E10, a blend of 10% ethanol and 90% gasoline, is generally the maximum blend allowed by the EPA and is mandated in only a handful of states. However, more than 90% of the gasoline sold in the U.S. is a blend of some kind, and the EPA is considering raising the limit to 15% ethanol (E15). In theory, that could mean far more ethanol sold.

But that's just in theory. Twelve different automakers have come out against the proposal, including heavyweights Ford (NYS: F) , Honda, and Toyota Motors, saying that cars get fewer miles per gallon with ethanol-blended fuel, and a higher blend may even damage engines and void warrantees. Meanwhile, the American Petroleum Institute -- which admittedly has an interest in keeping blending low -- also made a statement recently saying that half the gas stations in the U.S. are not equipped to handle E15, and that E15 at those locations could damage equipment and pose a threat to the local environment.

A stream of difficulties
As for ethanol companies themselves, they have done poorly. By 2009, about 9% of all ethanol plants had filed for bankruptcy, including high-profile cases such as VeraSun and Pacific Ethanol, which emerged from a Chapter 11 restructuring in 2010 but has continued to struggle. The loss of so many companies hasn't separated the wheat from the chaff, however, as many have simply restructured, like Pacific Ethanol, or been purchased by survivors, as Green Plains Renewable Energy (NYS: GPRE) did with some of VeraSun's plants.

Even diversified companies have suffered. Grain king Archer Daniels Midland (NYS: ADM) recently reported earnings, and while it may have crushed estimates, it revealed a steep drop in profits, due largely to its ethanol operations. Ethanol profits dropped to $37 million in the most recent quarter, down from $121 million last year. Oil company Valero (NYS: VLO) comes at ethanol from the other direction, but suffered a similar downturn, reporting a drop in ethanol profits from $44 million to just $9 million. The Andersons (NAS: ANDE) was the worst off, reporting Monday that ethanol profits had dropped from $3.6 million to just $0.1 million, barely avoiding a loss, and adding fodder to my underperform thesis for the company.

The Foolish bottom line
Obama is pushing hard for more ethanol use, and some companies, such as Pacific Ethanol, are exploring production with other inputs such as algae, wood, and grass. These other forms may be more economical and have fewer negative side effects. Unfortunately, they are a long way from the mass production corn ethanol enjoys. Ethanol isn't going away anytime soon, but don't be surprised if the companies that produce it do.

Don't let ethanol's troubles scare you away from energy investing, though. Three of The Motley Fool's top Rising Stars have put together a free new report with their top three stocks for $100 oil. Enjoy, and Fool on!

At the time thisarticle was published Fool contributor Jacob Roche holds no position in any of the stocks mentioned. Check out his Motley Fool CAPS profile or follow his articles using Twitter or RSS. The Motley Fool owns shares of Ford Motor. Motley Fool newsletter services have recommended buying shares of Ford Motor. Motley Fool newsletter services have recommended creating a synthetic long position in Ford Motor. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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