Published: March 1, 2010

A friend just forwarded me an email from the editors of Mother Earth News, an eco-centric DIY magazine, compiling some of their favorite stories from the publication's past 40 years. Those snowbound in the mid-Atlantic may appreciate imagining a little revenge on Punxsutawney Phil by reading the how-to-serve-groundhog feature from 1984, while the morbidly frugal may want to bone up on a 2003 feature on building your own coffin ("it makes a great coffee table or storage trunk before its final use").

Those with a green bent, like me, can enjoy a good selection on alternative fueling options for cars. In 1981, when a gallon of gasoline cost an inflation-adjusted $3.23, the magazine ran a lengthy feature on converting a pickup truck to run on wood chips, through the addition of a wood gasification system to your engine. Though not very sporty looking (part of the system includes a converted 40-gallon water heater tank), it got about a mile for every pound of wood scrap and tree trimmings.

A 1971 feature details how an English farm dweller turned a combination of pig and chicken poop into a source of cheap and cleaner-than-gasoline source of methane to run his car.

Most impressive was a 1979 feature on how one American converted his Opel sportscar into a hybrid over the course of a few weekends and evenings using commonly available parts. The resulting converted car, with the same curb weight, got 75 miles-per-gallon! The car was even given the regenerative breaking the Toyota Prius boasts, with none of the breaking trouble, I presume.

Most of us don't have the time or the inclination to tinker with our car engines to make them run on another fuel. But we don't have to anymore. While biofuels used to be an endeavor for hobbyists and hippies, they are fast becoming the core of a multibillion-dollar industry.

Most of us in the U.S. are familiar with one type of bio fuel: corn-based ethanol, which for years was seen more as an excuse to send political pork to Mid-Western farmers rather than serious policy. The Energy Independence and Security Act of December 2007 gave biofuels a huge boost by mandating that the country use 36 billion gallons of ethanol by 2020, up from seven billion when the bill was passed (the nation uses a total of 120 billion gallons of gasoline annually).

Just this month, the EPA gave another boost by determining that corn-based ethanol provides a net 21% reduction in greenhouse gases over gasoline, meaning corn-based ethanol can qualify as an "advanced biofuel" under favorable federal regulations. That will help justify a proposed increase for later this year in the allowable blend of ethanol in gasoline from a voluntary 10% to 15%.

Those three facts alone should make investors sit up and take notice. After all, how often do you come across an industry with a federal mandate to quadruple its market by the end of this decade, that is receiving active support now in expanding that market plus is found to get the country further along the goal of cutting greenhouse gases?

But investing in biofuels stocks isn't a slam-dunk. Ethanol-related stocks got a huge boost in early 2008 after the EISA was passed, but by the middle of that year, criticisms of the effect of ethanol on the price of food supplies reached a crescendo, and the market turmoil added to the pressure on biofuels producers. Some that had been seen as good bets, like #2 ethanol producer VeraSun, went under and saw its assets sold off at a fraction of their value to refiners like Valero (NYSE: VLO).

Yet lately, we're seeing increasing strength in the shares of the surviving ethanol-related companies. Commodity broker Archer Daniels Midland (NYSE: ADM) has used the weakness to build up its position as an ethanol refiner, building its own plants and buying up other capacity. It's now the largest producer in the country, and is in a position of strength if gasoline prices surge and demand for ethanol materializes. Similarly, second-tier ethanol players that survived the worst of it, like The Andersons (Nasdaq: ANDE), are seeing good relative performance lately, too.

But in this environment, I'm not sold on investing in any domestic ethanol producer just yet. There are a few reasons for that. Let me talk about the macro ones I believe could drive long-term movement in ethanol.

One is the global economic uncertainty: The debt troubles of Greece, Spain and other countries in Europe have increased the risk of the common euro currency taking a beating. And if investors flee the euro, that almost certainly means the dollar will strengthen. And when the dollar strengthens, there is a strong inclination of oil prices to fall. That's because oil is priced globally in dollars, meaning OPEC can ease its pricing to placate its best customer (us) while still going home with as much money in their own currency as always. (It's no coincidence that 10 years ago 99-cent gas coincided with the unrivalled strength of the U.S. dollar.) If oil prices drop, ethanol is a lot less attractive to refiners, retailers and ultimately us drivers.

Another reason I'm not convinced about domestic ethanol just yet is the concern that using up edible crops (or at least arable land to grow inedible, ethanol-producing corn) will spark another wave of outrage if food prices spike again domestically. And that is a significant possibility if the dollar doesn't strengthen and the U.S. middle class continues to get squeezed from all directions.

Food supply shocks like that are also why China mandates that no biofuels in its country be derived from edible crops. The leading biodiesel maker there, Gushan Environmental (NYSE: GU), collects waste cooking oil for restaurants for its product and eventually will make fuel from a non-edible pistachio plant that grows well on land otherwise unsuited for farming.

Lastly, perhaps the primary reason I'm wary of domestic ethanol stocks is that I expect Brazil will be the most effective ethanol producer. For one, Brazil is the dominant grower of sugarcane in the world, producing about one-third of all cane.

Ethanol can be made from sugarcane, and in fact cane is a superior raw material for ethanol, since more of it converts into energy, and does so more easily. By one measure, sugarcane ethanol returns eight times the energy used to produce it, while corn ethanol returns just 1.3 times the energy used to make it. Now add in the fact Brazil not only exports a lot of sugar, but also makes a lot of ethanol too.

In 2009, Brazil is estimated to have produced 28 billion gallons of ethanol. Most of that was used domestically, accounting for half of Brazilian automobile fuel. But exporting it to markets that offer a greater return, like the United States directly, or through intermediary countries that sidestep trade barriers, is hardly unrealistic. And if you project an export market for American ethanol, consider that it is China and Brazil which have just inked a deal to start sending Brazilian ethanol east.

In this environment, I'm putting the odds favoring a company called Cosan (NYSE: CZZ), the largest sugar producer in Brazil and also the biggest ethanol producer. The company just signed a deal with Royal Dutch Shell for co-generation and marketing of each other's fuels in a bid to lay the groundwork for a global ethanol giant.

CZZ has more than doubled in the past year, jumping from $4 to nearly $9, giving it a market cap of $2.8 billion, and it has held up well in the recent market retracement.

Cosan should also benefit from strong prices in the world market for raw sugar this year too (Brazil sells its crop into the world market this summer). I don't think it's time to buy it just yet, and commodity-based stocks can be very volatile, but if you're interested in profiting from biofuels, keep your gaze to the south.

-- Brendan Coffey
Editor
Cabot Green Investor