The Energy Report: With so many types of products, can biofuels be considered a single industry?
Ian Gilson: Biofuels is a name we give to many products from several processes that produce fuels based on sources other than coal and oil. As such, biofuels are really many industries. The two major industries are ethanol and biodiesel. Others include fuel from algae and alternative cellulosic materials. Ethanol and biodiesel are sold into two different industries and serve different markets. Ethanol is mixed with gasoline and biodiesel is mixed with diesel fuel. However, biofuels in general share some common ground in that they could reduce our dependence on foreign fuels.
TER: How efficient is biofuel production? Is there a real value proposition without tax credits?
"We have to develop enzymes that will convert materials at a profitable rate. There's a research effort to find better enzymes to produce sugar and better yeasts to make ethanol. When somebody finds one of those, it will be extremely profitable." –Ian Gilson
IG: That depends largely on the size of the manufacturing plant, which impacts the cost of production for both ethanol and biodiesel companies. In the case of biodiesel, there are many small plants that were built to capture the blending credits in local markets or to use excess soy oil from beans grown by farmers. The cost of biodiesel also depends on the feedstock used. The Environmental Protection Agency (EPA) has estimated that biodiesel production costs for soybeans was close to $2.75 per gallon (/gal) in 2010. The large ethanol and biodiesel plants are still profitable without tax credits while the small plants are not. In many cases, they were built to capture the credits. It has been reported that of approximately 150 biodiesel plants in the U.S., only 40 were still operating at the end of April. A statement by the U.S. Navy quoted costs of $15.25/gal in late 2011. This seems rather high to me.
The lack of profits in both areas will probably reduce the number of productive plants—those with cash flow above the cost of capital—below the number needed to meet the mandated levels. This is particularly so with biodiesel. Without profits, plants will close and no new plants would be built, no matter what the mandates are. The government is faced with reinstating the subsidies, as it did in 2010 after ending them in December 2009. Some state subsidies still exist, but they are small and only apply to limited quantities and small plants.
TER: How do U.S. subsidies compare with Brazil and other countries?
IG: Most European countries subsidize biodiesel through lower taxes, and tax relief varies by country. Brazil produces ethanol from excess sugar, with spent sugar cane used as a fuel. However, in recent years the sugar plantations have not been replanting with new cane. Because new cane produces more sugar than older canes, the yield has declined, and Brazil now imports ethanol from the U.S. Europe has been reducing its subsidies on biofuels over the past few years. At this time in the U.S., there are agricultural subsidies, but not fuel subsidies.
TER: Conservative governments are generally against mandates. Is this year's election particularly important for biofuel industries' outlook?
IG: First of all, the mandates have been in place for some time. A large number of government employees are involved in governing those mandates within the EPA. I doubt very much whether any future president would do away with the EPA.
As far as the renewable-fuel mandates are concerned, I think that appeals both to Republicans and Democrats. The fact that we can reduce our dependence on imported oil is good politically and economically. Although the price of oil goes up and down, it's ultimately going to go up because there's going to be less of it, and it gets harder and harder to find. Building an infrastructure with mandates would appeal to both parties, in my opinion.
TER: Do biofuels put demand pressure on food production? Is there risk of overusing land, fertilizer and labor for energy production?
IG: Even food has an energy component in its cost of production. In the case of ethanol, the corn used is feed corn, not food corn. Yes, it takes energy to grow corn, but that energy is partially recaptured. Ethanol production also produces an animal food supplement that partially offsets the food value of the corn.
TER: There has been significant pressure on these stocks, and valuations are certainly lower over the past year. Is it because of the expired tax credits?
IG: Not only that, but lack of profits due to a variety of factors have impacted both ethanol and biodiesel stocks. However, there are growth opportunities in biofuels. The use of alternative feedstocks for ethanol and biodiesel production is a major research area.
TER: The consensus opinion holds that the price of oil will ultimately increase. But does more costly oil make for higher ethanol and biodiesel prices?
IG: To a certain extent. If the cost of oil increases, then the production cost of biofuels would also go up. Fertilizers are made from products that come out of the oil industry. Methane, nitrogen and hydrogen come from oil. Growing crops requires fuel. But will costs go up at the same rate? Probably not.
TER: Ian, you mentioned that alternative feedstock for both ethanol and biodiesel were major areas of research. What new industries or improvements to existing industries could emerge from this kind of research?
IG: Let's take two cases: Making ethanol from starch—corn starch, potato starch, wheat starch—has been going on since antiquity. In doing so, we have tailored the enzymes and the yeasts that are required to be highly specific and very productive. When it comes to other cellulosic materials that are not like starch in their chemical structure, we have to develop the enzymes that will convert those into the sugars at the rate necessary for profitability . There's a research effort by a number of research companies to find better enzymes to produce sugar and better yeasts to make ethanol. When somebody finds one of those, it would be extremely profitable.
We're talking about something that could utilize wood celluloses, like barks or grasses. I believe cattle have four stomachs that are highly specialized to convert grass into energy. What we need is one of those stomachs, a relatively inexpensive one, to convert waste celluloses like grass into starch or sugar that can be converted by yeast into alcohol.
"The fact that we can reduce our dependence on imported oil is good politically and economically." –Ian Gilson
The other major research focus is to find a cheaper source material, and that brings me to the topic of algae, which are specialized and relatively easy to grow. They do require some energy, but they can consume waste carbon dioxide and waste heat. They are cheap in many ways but are currently expensive in their use of land. If we can develop a cheaper way of farming the algae, then it would be a low-cost, raw material source and therefore a low-cost diesel fuel. Both enzyme- and source material-focused research present major opportunities in ethanol and diesel fuel, which could lead to productivity improvements that would make somebody a lot of money.
TER: On that note, you follow OriginOil Inc. (OOIL:OTC), a licensing- and royalty-based research company. How is the company contributing to biofuel-related research?
IG: OriginOil has developed a unique, patent-pending process for separating oil from the water and biomass produced from growing algae. The company has recently demonstrated that this technology can be used to separate the oil, water and solids in the water used for fracking. The oil separates from the water, and the sediment sinks to the bottom. That water can then be reused. That increased oil recovery has an economic value far in excess of the cost of the process. The technology that can be licensed on a fee or royalty basis, and infrastructure doesn't have to be built. This could be a major win for OriginOil. This is a potential gold mine.
TER: You've got it rated Outperform with a target price of $6, which represents something like a 400% implied upside from current levels.
IG: A 1% or 2% royalty on the fracking process could generate $1 per share or more in the next three to four years.
TER: This is a micro-cap company, and the first thing I noticed was that it has lost 76% of its market value in the past year, and this was a very small company to begin with. Yet insiders own only 21% of the company.
IG: Well, somebody had to finance the R&D.
TER: So, the financiers diluted out the original owners then.
TER: At this low market cap it just seems that insiders should own more.
IG: They have put a considerable amount of their own money into this. It's not like they have just gone out and floated stock and sold it and then printed shares for themselves. They have employed and continued to employ a significant number of research people. And, they have come up with products that have a market, which will generate income in the future with very little in the way of a cost structure because the costs are being absorbed now. When the revenue comes in, the cost based on that revenue will be very small. So you're looking at a tremendous increase in gross margins and in profits.
The reason the stock has gone down is because the market at the moment is not paying very much for micro-cap stocks. It's not just OriginOil. Many other very small companies have lost market value due to the fact they're considered to be high risk, and the market is moving away from risk at this point.
TER: You are following Pacific Ethanol Inc. (PEIX:NASDAQ). What is your thesis for this company?
IG: Transportation costs are significant in the total production cost of ethanol. The closer you are to corn production, silos and the farmers who grow it, the lower your incidental costs. It so happens that Pacific Ethanol's plants are in the western United States, where the company has a very strong marketing position.
TER: Its geography gives it the edge?
IG: Yes. That's the benefit, in addition to the fact that Pacific Ethanol has a subsidiary, Kinergy Marketing, which is also in a good position, marketing ethanol that others produce for a fee. It gives the company a major advantage over its competitors, and it's probably the most important aspect of the company. Ethanol is a commodity. You can't distinguish one producer's ethanol from anybody else's. To be able to market it is worth something, in my opinion.
TER: You are following FutureFuel Corp. (FF:NYSE), which has a rather nice market cap of around $387 million ($387M). It has two major customers in its chemical division that have reduced orders.
IG: Well, it's interesting that customers have decided for one reason or another to reduce their purchases of two of the products that the company makes on the chemical side of the business. The market dynamics have changed. In one case, the generic competition for the company's post-emergent herbicide made for Arysta LifeScience North America has come under significant pressure. In the other case, it's the bleach activator, the little blue specks that you see in Tide powder detergent. The market has been moving away from powders to liquids for years now, and so the customer, Procter & Gamble Co. (PG:NYSE), doesn't need as much.
However, the company is still making a fair amount of money, and there is not as much of a decline in profits as one would have thought. The importance of those products and the cash flow from the chemicals side is positive. You don't take profits to the bank. You take cash flow to the bank. I'm talking about net-free cash after capital expenditure.
FutureFuel is also a distributor of diesel fuel. It has a transportation complex that it built in the last few years for distribution of diesel fuel and blended diesel fuel at a relatively low cost. So it got a blender's credit. When blenders' credits were eliminated in December 2009 and more than half of the industry shut up shop, the government realized that without those credits there wouldn't be any biodiesel produced. So at the end of 2010, the credit was reinstated for a full year and the plants opened up again. The situation now is very similar. If the government wants its mandate to be met, it has to provide economic incentives to produce the fuel, be it ethanol or biodiesel. In my opinion, when push comes to shove, there will be some credits available to bring capacity back on-line.
TER: You upgraded FutureFuel back on February 23 from Neutral to Outperform. What was the reason for that? Was it oversold at that point?
IG: Yes, plus the fact that the company makes a graphite product that was designed to be used in hybrid and electric car batteries. That's a good business, ultimately. And the company pays a 4% dividend and has the cash flow to support that dividend. The plant is still trying to optimize its biodiesel production process, and the company is doing that. Basically, this is a value that is well in excess of the current stock price.
TER: It's very interesting to see a stock with a market cap of under $400M paying a dividend. Do you expect it to continue with that after this year?
IG: The dividend started out as a special dividend, and then it was made a regular dividend. Companies don't do that unless they expect to generate the cash from operations to support that dividend and possibly increase it. Net-free cash flow is positive and there is no reason to cut or eliminate the dividend.
TER: Many thanks to you, Ian.
IG: Thank you.
Ian Gilson, PhD, MBA, CFA joined Zacks in 2006 as a senior analyst covering the graphics display industry as well as some special situations. His current coverage includes several micro-cap companies in the technology sector. He has 20 years of experience as a sell-side analyst covering small- and micro-cap companies. His buy-side experience includes three years as a money manager with Manning & Napier and 13 years with the Harris Trust and Savings Bank as an analyst and money manager.
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1) George S. Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Ian Gilson: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family is paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story.