by Zoe Van Schyndel,CFA
Concern over pollution, air quality and the availability of gasoline has elevated biofuels as a key solution to environmental and energy problems. However, a closer look at the issue reveals that these fuels are unlikely to be a magic potion for energy needs. There are a host of problems associated with biofuel production ranging from water, air and land pollution to the distortion of agricultural commodity prices and the destruction of sensitive ecosystems. In addition, these fuels make up a very small percentage of the energy marketplace, which would require difficult and expensive measures to change. In this article, we'll take a look at biofuels, examine their benefits and drawbacks and examine what these new energy products might mean for the environment and for investors.
What are biofuels?
Biofuels originate from some type of biomass, or biological matter that can be used for fuel. The two most common types of biofuels are bioethanol and biodiesel. Bioethanol is created by fermenting sugar or starch; corn and sugar are most often used. Biodiesel, on the other hand, is made by combining alcohol, usually methanol, with vegetable oil, such as that found in soybeans, palm oil, animal fat or recycled cooking grease. Once biomass is converted into liquid fuel, it can be used for a variety of energy needs. Ethanol and biodiesel are often blended with gasoline and diesel as additives to reduce vehicle emissions or may be used in their pure forms as renewable alternative fuels.
In corn-belt states like Illinois, ethanol additives appear in close to 50% of the gas sold in the state, according to the Illinois Corn Growers Association. Ethanol is a home-grown fuel, but it is also an attractive additive for several other reasons. Adding ethanol to gasoline reduces the amount of hydrocarbons and carbon monoxide in vehicle exhaust, and in its pure form, ethanol has a very high octane rating, which generally means it will provide more power.
However, although ethanol is considered a cleaner burning fuel with less carbon monoxide and other toxic emissions, the troubling thing about using corn for energy is that the fossil fuel energy used to create ethanol is very high. According to a 2002 report by the U.S. Department of Agriculture, ethanol yields only 34% more energy than is used in its production; however, other studies, such as one by David Pimentel and Tad W. Patzek published in Natural Resources Research in 2005, suggest that corn and other ethanol crops require more fossil fuel energy that the fuel they produce. In addition, corn production also requires herbicides and fertilizers, which can contribute to soil and groundwater pollution.
Despite these issues, the U.S. has vastly expanded the amount of acreages devoted to corn, a move that has been driven in part by subsidies and tariffs that restrict imports. According to a 2004 report by the California Energy Commission, the U.S. government has also maintained national tax incentives to encourage ethanol production since 1978.
The Sweet and Sour of Sugar
Brazil is the current poster child for biofuels usage. Unlike the U.S.'s dependence on corn, Brazil relies on sugarcane as its primary ethanol feedstock. After OPEC crippled the Brazilian economy with its oil embargo in the 1970s, Brazil's government made a concerted effort to wean itself from oil. After years of heavy subsidies and tax incentives, by 2005, 73% (according to a January 2006 article in Fortune magazine) of cars sold in Brazil came with "flex fuel" engines, which are capable of running on any mixture of alcohol or gasoline.
Sugarcane has also proved more efficient than corn; sugarcane provides 570 - 700 gallons of ethanol per acre, while corn yields 330 - 420 gallons (Nature, December 2006).
Sugarcane does have its negative side as well, in both human and ecological terms. Most Brazilian cane is cut by hand, which can be a dirty and deadly business for workers in the heat as some sugarcane growers host terrible working conditions. In addition, the cane fields are often burned before harvesting to make it easier to harvest and to flush out pests like snakes. Unfortunately, this burning process contributes to the release of green house gases. Furthermore, each additional acre allocated to sugarcane means that natural vegetation is displaced somewhere to make the crop land available, further exacerbating the negative impact of this fuel.
Palm oil is relatively inexpensive to produce and that can make it attractive as a feedstock for producing biodiesel. Biodiesel is biodegradable and nontoxic, and can be used alone or blended with petroleum diesel. In addition to being used as motor vehicle fuel, biodiesel can be used as heating fuel in both domestic and commercial applications.
Southeast Asia, Indonesia and Malaysia in particular account for the majority of palm oil production, most of which goes for human consumption or other uses besides energy. Unfortunately, oil palm trees are often grown on newly cleared rain forest or peat swamp, thereby destroying habitat and opening up the remaining forest to poaching. While the oil itself may be a more environmentally friendly alternative compared to fossil fuels, the processes that are used in growing palm may contribute to significant damage to the environment.
Biofuels Reduce Food Supply
Corn kernels and sugarcane juice are common feedstock for creating ethanol, while palm oil has a central role in biodiesel. What these commodities all have in common is that they have a competing purpose of being a source of food and fuel.
The conundrum of food versus fuel and the increased demand for these products as a feedstock for biofuels can cause increases in commodity prices. Such an increase generally translates into higher food prices for consumers. Furthermore, even if price isn't a concern, the supply available is also a hotly debated issue, and some critics contend that these competing interests could lead to food shortages. In November 2007, Oxfam, a leading humanitarian aid agency, cautioned the European Union to ensure that its plans to switch to biofuels won't hit farmers in poor countries. The agency warned that increases in biofuel production could trigger a "land grab" that could force poor farmers off their land and reduce the land available for food production.
Investment opportunities to participate in the biofuels boom range from newly listed companies like, Biofuel Energy Corp. (Nasdaq: BIOF), which is a development-stage company that builds and operates ethanol production facilities in the midwestern U.S., to long-established giants like Archer Daniels Midland (NYSE: ADM) and ConAgra Foods (NYSE: CAG). Furthermore, as venture capital flows into startup biofuel companies, this will provide additional opportunities for investors to participate in the boom as these companies become public traded.
The Way Forward
Biofuels may be one of the keys to weaning ourselves off the petroleum merry-go-round, but several issues must be addressed to make them a true competitor with petroleum. Until the holy grail of biofuel feedstocks is found, it is likely that there will be continued pressure on agricultural products as the dual interests of food and fuel fight for the same raw commodities. Opportunities for investors are growing in this niche and, as more companies go public, there are likely to be additional options to choose from.
Good investing, Kingsley.