IE 11 is not supported. For an optimal experience visit our site on another browser.

Will ethanol prove to be profitable investment?

Three makers of the corn-based fuel have filed to go public. Investors could score big, but there’s plenty of risk.
/ Source: Business Week

Depending on who you believe, ethanol is either crucial to weaning the U.S. off foreign oil or an overhyped fad surviving on generous government subsidies. But even as the plant-based fuel is becoming a more important ingredient in the American gas supply, there have been few opportunities for investors to bet on ethanol’s prospects.

All that is about to change. Three Midwest ethanol companies have recently filed to go public — Aventine Renewable Energy, VeraSun Energy, and Hawkeye Renewables. The companies share some similarities. All three produce ethanol from corn and have plans to expand their operations. And each has enjoyed soaring profits in recent months as ethanol prices have surged.

Potent developments
It’s probably good timing because of the interest in ethanol and the profits behind it, says Joseph Agnese, a senior industry analyst with Standard & Poor’s. It’s all positives. Even so, he cautions that since ethanol industry profits climb with oil prices, there’s also a lot of risk.

Indeed, the last year has been a whirl of excitement and controversy, unexpected, perhaps, for an industry based in cornfields and facilities that cook and mash the kernels. Despite a 51-cent-per-gallon subsidy on ethanol produced for fuel, the 2005 Energy Policy Act mandates an increase in U.S. ethanol production to 7.5 billion gallons in 2012, almost doubling the 2005 output of 4 billion gallons. To protect American producers, there is also a widely criticized tariff on importing ethanol from Brazil, which makes it out of sugarcane.

Before this year, ethanol was mixed into gas in a small number of states, including California, New York, and parts of the Midwest. But this spring refiners in parts of the Northeast and Texas increased their use of ethanol in gas as they phased out methyl tertiary-butyl ether (MTBE), a chemical that contaminates drinking water.

Sunny prospects
Both MTBE and ethanol make gas burn cleaner. These events have come amid growing public sentiment that, whether for environmental or political reasons, a domestic source of clean-burning gas is a very good idea.

The payoff for ethanol is that the New York Harbor spot price on June 9 was $4.50 per gallon, up from about $2.30 at the beginning of the year. According to Platts, wholesale prices have also climbed in the Midwest, where the difficulties of transporting ethanol are less pronounced, though the increases have not been as precipitous.

With ethanol prices soaring, the prospects for the IPO candidates look bright. VeraSun reported gross profit of $29.3 million for the quarter ending Mar. 31, up from $6.2 million for the same period in 2005, as revenues jumped from $44.9 million to $110.7 million. Even more promising, operating margins are surging, suggesting strong profits as revenues grow. Operating profit was 24% of revenues in the first quarter this year, up from 9% in the year-earlier period.

A little skeptical
At Aventine, revenues soared 60%, to $313.5 million, in the first quarter, as net income doubled to $12.2 million. Hawkeye saw sales rise 55%, to $24.8 million, while net income tripled to $6.8 million.

None of the companies returned requests for comment; they’re barred from making certain public statements as part of the Securities & Exchange Commission’s mandate of a quiet period around IPOs.

Michael Gallipo, a portfolio manager at Citizens Funds, says that despite the excitement surrounding ethanol he’s not sure if we’d actually participate. “The contrarian investor in me is a little skeptical when you’ve got three of them coming to market at the same time,” Gallipo says. Management seems to think it’s a good time to sell some of their stock.

Investing dilemma
Bob Dinneen, president of the Renewable Fuels Association, an industry trade group, called the perspective kind of cynical. I think it’s a good time to expand. He prudently declined to say which of the three outfits, each an RFA member, he would bet on.

Calvert Funds Chief Social Investment Strategist Julie Gorte was also a bit more optimistic. She thinks oil companies should be looking toward ethanol outfits with an eye for acquisition. And a law requiring ethanol increases provides a nice environment in which to grow, but it’s not enough, especially because the sector remains heavily dependent on government policy.

For fund groups, like Citizens and Calvert, that bill themselves as socially responsible, ethanol also presents a dilemma. It’s a clean-burning fuel that when produced from corn on a mass scale requires enormous quantities of land and polluting fertilizers.

Why not more?
For a preview of how the IPOs may turn out, investors might want to look to Pacific Ethanol, a Fresno, Calif. company that markets ethanol. The stock closed at $24.91 on June 9, up from its Jan. 3 close of $11.05, but way down from its May 11 high of $44.50.

With so much going on, why haven’t there been more ethanol investing opportunities? Decatur, Ill.-based Archer Daniels Midland is by far the largest domestic producer (see BusinessWeek.com, 5/3/06, "More Than Ethanol Driving ADM"), but the fuel doesn’t make up enough of the company’s revenues for it to be considered strictly an ethanol play. Meanwhile, scores of small private outfits chip into the U.S. ethanol supply. These three companies heading for IPOs may be investors’ best chance to bet on what could be the fuel of the future.