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America's Next Big Energy Bubble

By Rob Fannon, editor Phase 1 Investor
Friday, September 12, 2008

It's like beer... but with a whole lot more alcohol.
 
As yeast ferments corn sugars, it produces ethanol... a gasoline alternative and once the darling of the "green energy" complex. Ethanol's fortunes looked bright when President Bush declared America "addicted" to oil in 2006 and pledged hundreds of millions to treat the problem. Big ethanol producers soared... Pacific Ethanol (PEIX) was up more than 200% in the first five months of the year.
 
Since the bubble burst, however, ethanol investors have gotten killed. PEIX is down 85% over the last 12 months. It's the same story with VeraSun (VSE), another big ethanol name. VSE investors have lost nearly 70% this year.
 
But I think a bigger bubble's brewing... one that can make early investors several times their money.
 
You see, the Department of Energy has put real money behind Bush's promise. It spent $700 million on alternative fuel technologies last year. And our neighbors to the north followed suit: Canada budgeted $500 million for its NextGen Biofuels Fund in 2007.
 
The Energy Independence and Security Act calls for the use of 9 billion gallons of ethanol this year. Ethanol companies are selling their product for about $2.50 per gallon. So today, the market's about $20 billion. But the legislation mandates ethanol use to quadruple by 2022, to more than 36 billion gallons annually. If the price crawls up to $3 per gallon, the potential ethanol market will reach a staggering $100 billion.
 
That's part of the reason we've seen corn prices rise nearly fourfold since Bush's 2006 speech. Most U.S. ethanol is made from corn. But those high corn prices have been poison for ethanol producers. Pacific Ethanol posted $460 million in sales last year. The problem is it cost the company $430 million to produce those sales.
 
With corn prices where they are today, corn-based ethanol is just not a viable business. But you don't need corn to make ethanol.
 
"Cellulosic ethanol" comes from just about any part of any plant: wood, grass, sugarcane, even banana peels.
 
Just like corn, cellulose – what gives a plant its structure – can break down into sugars to produce ethanol. But cellulose "feedstock" is cheap and abundant. Scrap wood and discarded yard clippings are practically free, compared to $6-$8 per bushel of corn. So theoretically, a gallon of cellulosic ethanol could cost half as much to produce.
 
Right now, cellulosic ethanol production is confined to labs. The ramp-up to commercial scale is a few years away, which is where the investable opportunity is today... and how this story came across my radar screen.
 
There are two ways to invest in cellulosic ethanol... First, you could buy stock in enzyme suppliers. These are biotech and specialty chemical companies that produce the enzymes needed to break down cellulose. Or you could buy stock in integrated producers, companies building cellulosic ethanol production plants.
 
It's too early to tell which is the best route. But it's a safe bet that several winners from both sides will emerge from the race to the next energy bubble.
 
I just visited one of the most promising commercial demo plants and have plans to visit others in the coming weeks. Plus, I'll be speaking with enzyme suppliers that aim to tap into this market by enhancing the production process on a commercial scale.
 
In the coming weeks, I'll tell you what I find...
 
Good investing,
 
Rob Fannon




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