This Bill Wants to Cut Ethanol Production in Half

The Renewable Fuel Standard, or RFS, was first passed in 2005 to mandate the use of biofuels in America's transportation sector. Despite being amended in 2007, it still has some pretty big flaws that need to be addressed. Now, four members of Congress have drafted legislation that seeks to make some pretty important changes. The proposed bill is far from perfect, but it could devastate the country's biggest ethanol producers and even disrupt the global ethanol market. Here's what investors need to know and two potential opportunities to keep in mind.

Renewable Flawed Standard
There's no debating that the RFS has done exactly what it was designed to do: create a market for American biofuels. In just a few short years, the United States went from a marginal producer of ethanol to the world's largest, surpassing even the mighty Brazil.

Source: Energy Information Administration.

The mandate caps corn ethanol production at 15 billion gallons per year, which is smart and necessary. However, current laws dictate that an additional 16 billion gallons per year of second-generation cellulosic ethanol must be produced by 2022. That brings the total amount of ethanol produced to 31 billion gallons per year and poses several problems.

That thing called math
Sure, ethanol blends could be increased from the mandatory 10%, or E10, to a still safe 15%, or E15. But even then, producers would be swimming in ethanol. The problem is that the original mandates called for growing fuel consumption -- perfectly in tune with reality in 2005 -- but increased efficiency and decreased driving have actually sent fuel consumption in the opposite direction.

Looking at historical gasoline consumption and ethanol production demonstrates the misguided targets of the current mandate. If America were to use all of the ethanol it produced in 2022, annual gasoline consumption would have to swell to 200 billion gallons! The new fuel efficiency targets announced last year should actually cut consumption to half of that amount.

Source: Energy Information Administration. Fuel ethanol sold equals production less net imports.

The blending requirements could be lowered relatively easily. Unfortunately, they represent only one major flaw. The RFS heavily favors ethanol while neglecting to give equal opportunities to other, potentially better biofuels. You'd never know it from current laws, but the EPA considers methanol, butanol, hydrogen, natural gas, and even electricity as renewable fuels. By making detailed procedures for ethanol, the government has inadvertently abandoned these other alternative fuels that can be compatible with current engines and infrastructure, as well as cheaper, cleaner, or more energy-efficient.

The RFS Reform Bill is a good start, but ...
A group of lawmakers from both parties proposed legislation to overhaul the mandate. The bill intends to slash the production mandate by 42%, limit blends to E10, and completely disallow corn ethanol from the mandate. At face value, the proposed law has good intentions and addresses the 31 billion-gallon elephant in the room, which lawmakers will have to deal with eventually.

Unfortunately, the bill does little to encourage research into or the eventual adoption of other alternative fuels. The early transcripts from the bill also show that it is deeply rooted in the food-versus-fuel debate. Ethanol critics love to point out that more than 40% of the country's corn crop goes to ethanol. But it's a bit misguided to stop counting there. Ethanol producers only want the starch in corn. Once that's extracted with enzymes, the corn is dried again and sold back to farmers as animal feed. Thus, the net acreage devoted to ethanol is really closer to 17%.

Not looking at the facts (ethanol blends with 31 billion gallons of production) has already created a big mess today. If we're going to overhaul the RFS, shouldn't we address all of its shortfalls with the facts in mind? Nonetheless, it does address one major flaw: Investors will want to begin reviewing their options should it pass.

Risks for major producers
Reform could be bad news for large corn ethanol producers such as Archer Daniels Midland and Valero . The two companies have a combined annual ethanol capacity of nearly 3 billion gallons, which is almost one-quarter of the country's production. It doesn't take much imagination to see how devastating that could be for investors, who have been hit by fluctuating ethanol margins in the past.

The largest producers are big enough to refocus production to cellulosic feedstocks, but it will be a painful corrective process that will take years to complete. Depending on the fine print included in the potential legislation, sugarcane ethanol could also be disqualified from the blending requirements. The United States has been a consistent net exporter of ethanol in recent years, but imports from Bunge and Raizen are still important in times of drought and could be halted until both grow second-generation capacity.

Potential opportunities
While the bill could effectively exterminate smaller producers who aren't as resistant to volatility or don't have the ability to switch to second-generation feedstocks, there are opportunities in the chaos.

Although it may not affect the fundamentals for the company, cellulosic-fuel producer KiOR could use the changing market conditions to supercharge its growth. KiOR will have two biorefineries in operation by the end of 2014, with an annual capacity of nearly 50 million gallons. If the company reaches efficiency targets, production could increase to 70 MMgy. In that scenario, without changes to the current mandate, the company could sell its fuels for $5.24 per gallon. Profitability could soar even further if new legislation hands out more credits to cellulosic ethanol producers to reinforce growth, which could spur the company to add even more capacity.

A non-obvious play on disappearing corn ethanol production is Gevo , although it comes with substantially more risk. The company's platform aims to retrofit existing ethanol biorefineries to produce higher value isobutanol, which has applications in fuels and blendstocks, specialty chemicals, plastics, and rubbers. After scoring some major wins in a recent legal battle with Butamax, a joint venture between BP and DuPont, the company can now focus on proving its technology at commercial scale.

Gevo's Luverne, Minn. biorefinery. Source: Gevo.

After contamination issues dealt a blow to its scale-up timeline last year, Gevo is now ready to restart its Luverne biorefinery. A successful ramp-up into 2014 would demonstrate the feasibility and profitability of its platform and open the door for its future. Management has stated that partners and potential partners courted by the company represent more than 1.2 billion gallons of ethanol capacity waiting to be put to better use. Add a bill that could make corn ethanol obsolete, and an entire industry could look to Gevo for saving their operations.

Foolish bottom line
Keep in mind that a bill was only drafted and is a long way from becoming law. Nonetheless, investors in Valero and ADM should be aware that changes to the RFS are inevitable over the next several years. Future reform may not go as far to nix corn ethanol from blending requirements, but you can expect drastic reductions to total production volumes. The important thing to remember is not to panic -- opportunities always exist in this thing called investing.

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The article This Bill Wants to Cut Ethanol Production in Half originally appeared on Fool.com.

Fool contributor Maxx Chatsko has no position in any stocks mentioned. Check out his personal portfolio, his CAPS page, or follow him on Twitter, @BlacknGoldFool, to keep up with his writing on energy, bioprocessing, and emerging technologies.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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